RISK

In the media, options are often portrayed as being particularly risky. The truth of course depends on how they are used. Options can be used to reduce risk, i.e. in much the same way as an insurance policy. On the other hand, some operators will happily take on unlimited risk if compensated with a suitably generous premium. Whereas a motor insurer for example can spread risk across many different policies, it may be harder for an options seller to spread risk as many of the products traded will be closely correlated. As such, it is argued that a large shock to the markets could result in price movements which options sellers cannot properly hedge against and which might therefore result in liquidity problems, for the firm and the wider market. Examine the charts below to see the resulting pay-offs for put and call buyers and sellers and hence see the unlimited downsides options sellers may face.

Assumptions: Strike price = 100, Premium = 20                 Links