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How Can You Lose Money Trading Options?
The reasons to trade options include hedging currency risk, leveraging trading capital and locking potential profits as the market swings up and down. International businesses use options for risk management while speculators search for profits. To be successful one must adapt Warren Buffett’s first two rules on investing to options trading. Rule one is not to lose money and rule two is to always remember rule one. So, how can you lose money trading options and how can you avoid doing so?
Formal Forex Markets and Counterpart Risk Management
The vast majority of option trading takes place in on the CBOE, Chicago Board Options Exchange. You should be trading is this market to avoid counterparty risk, the risk that the other party in the trade will not fulfill their part of the contract.
Counterparty risk is the risk that the seller of an option will not sell when the buyer chooses to exercise the option. You buy a put on IBM believing it will go down and it does, substantially. You exercise the option expecting to sell at a strike price and substantially above the spot price where you will buy. It is payday! Thoughts of trips around the world sail through your head. Then, oops, the reason IBM is down is that the market is crashing and the seller of your put does not have the money to buy your stock! How does your risk management strategy avoid this situation?
Working through a strong intermediary helps avoid counterparty risk in option trading.
Be careful if you are trading outside of the CBOE because it is altogether possible to lose your money in an otherwise successful options trade.
Volatile markets are commonly the most profitable but these are markets where you can also lose big. Professional option traders develop a successful options trading strategy.