Trader, when you buy or sell a listed option, you incur two types of risks: the chance of being wrong about the direction of the underlying stock and the risk of being wrong about the time to expiration. This article will discuss each in detail.

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The direction of the underlying stock

First, let’s talk about being wrong about the direction of the underlying stock. When you buy a call option, you hope the stock price will go up so that you can sell your option at a higher price than what you paid. The opposite is true for put options. If you are wrong about which direction the underlying stock will move, your option may expire worthlessly.

For example, if you think XYZ Corporation (ticker: XYZ) is going to go up and you purchase a call option with a strike cost of $50, the stock will need to be above $50 when the option expires for you to make a profit. If it is not, your option will expire worthlessly, and you will lose the entire premium that you paid for the option.

Time to expiration

Options are a waste, which means they lose value as time passes. The closer an options contract gets to its expiration date, the faster it loses value. It is because there is less and less time for the underlying stock to move in the direction you need it to for your option to be profitable.

For example, if XYZ Corporation is trading at $48 and you buy a call option with a strike price of $50, the option will have some time value when you buy it because the stock price would need to move up $2 for the option to be in-the-money at expiration.

However, if XYZ is still trading at $48 when the option expires, the option will expire worthlessly, and you will lose your entire premium.

Volatility

It is a measure of how much the price of a security fluctuates. Options are sensitive to changes in volatility because it affects the amount of time value an options contract has.

If you purchase a call option on XYZ with a strike price of $50 when the stock trades at $48, the option will have some time value. It is because the stock price would need to move up $2 for the option to be in the money at expiration. However, if the volatility of XYZ increases, the option will have more time value. It is because a more significant move is needed for the option to be in the money at expiration.

The opposite is true for put options. If you purchase a put option on XYZ with a strike price of $50 when the stock is trading at $48, the option will have some time value, and it is because the stock price would need to decrease to $2 for the option to be in the money at expiration.

However, if the volatility of XYZ increases, the option will have less time value. A minor move is needed for the option to be in the money at expiration.

Interest rates

When you purchase an options contract, you pay a premium for the right to purchase or sell the underlying stock at a set cost. The premium comprises two parts: the intrinsic value and the time value.

They can affect the time value of an options contract. It is because a higher interest rate costs more to buy the underlying stock, reducing the demand for call options and putting downward pressure on prices. The opposite is true for put options.

Dividends

If you are long a call option, you have the right to buy the underlying stock at a specific price. You will no longer be entitled to the dividend if the stock goes ex-dividend before your option expires.

For example, let’s say XYZ Corporation is trading at $48, and you buy a call option with a strike price of $50. The stock goes ex-dividend, and the dividend is $0.50. The stock price will drop by the dividend amount on the ex-dividend date, which means that your option will be in the money by $0.50.

You will no longer be entitled to the dividend because you do not own the stock, and this means that your option will be less valuable than it would have been if the stock had not gone ex-dividend.