InvestorQ : Is it very risky to sell options; both calls and puts?
Aashna Tripathi made post

Is it very risky to sell options; both calls and puts?

shrinidhi Rajan answered.
3 years ago

There are quite a few reasons why the selling of options tends to work against you. There are 3 main reasons why these selling options work against you. Firstly, volatility is normally the culprit and it is this volatility which normally triggers these huge losses. You need to be cautious about that and manage your risk accordingly. Volatility, in fact, is a huge risk. Even if the price of the stock has not moved but volatility goes up, the price movement can go against you. Your stop losses can get triggered. At times overnight volatility can be quite dangerous for options as the options can create huge losses by the time you can even take any corrective action.

Secondly, quite often it is the overnight risk that works against you. In case of the Barings debacle, the earthquake in Kobe in Japan was the factor. The trader, Nick Leeson, had heavily sold straddles (calls and puts) on the Nikkei index and that led to the real problem in the options position. The risk was open and naked and that led to the capital being wiped out fully. This is a major issue for option sellers. Overnight events like rate cuts, Greek defaults and the Brazilian currency crisis can have a huge impact. More so in case of leveraged positions, where such losses can get magnified, manifold.

Finally, there is a very practical risk. Quite often, liquidity can be a major risk in options. We all saw this in the crisis of 2004 and 2008 in equity options. If you have sold a call and price moves against you, you find it hard to exit as there are no willing sellers in a volatile market. You end up paying a liquidity premium. That is when selling options becomes like what Warren famously described as weapons of mass destruction.