Question

How can using options be a very risky practice? Please give several examples  

Answer 1

Using options can result in a very high risk for the option holders.

A derivative financial instruments based on the value of underlying securities is called an option. Financially these underlying securities can be stocks. An option is a contract which gives the buyer of the option the right to buy or sell the underlying asset at a already determined rate which is called the strike price of the option. The option is a contractual right not an obligation to buy or sell.

The main aim of using the options is to hedge; either to offset or to reduce the risk of exposures. This way the investors' risk is limited from fluctuations in price. The main mechanism of using the options is the speculation of prices of options on the basis of current economic conditions.

Since the investing in options is based on speculations; a lot of fluctuations get automatically attached to it. Other than speculations the options traders can also use options to sell insurance to hedgers, this can prove to be risky. The risk of losing the premium paid on the options is always attached with the options.

Suppose, the strike price of the options as speculated by the option holder is $50 after 3 months and the price actually after 3 months becomes $ 65. The option holder invariably loses the premium paid and the difference of $15.