It is often stated that options are high risk investments, and it is true that options in the hands of a certifiable idiot, can cause deleterious damage to said idiots account. However in actual fact, options are no more risky than stocks.
People believe they are risky because of a fundamental misunderstanding of what an option actually does. An option merely transfers risk from one trader to another in exchange for risk in another form.
Lets consider the six possible one legged positions that a trader can undertake.
Lets assume that all the option strikes are the same and ATM and traded at fair value. If all six positions are initiated at the same time (ignoring cost of carry and brokerage) by one trader there would be no possible profit or loss.
Said another way, if six separate traders each entered one of the above positions, each trader would either end up with either a profit or a loss, of varying magnitutes. However, if the profit or loss of all six traders were added together, the result would be 0, NO MATTER WHAT THE STOCK PRICE DOES.
Now in reality, the contest risk (spread + commish) would ensure a slight loss overall.
So what we can see here is that options have not introduced any additional risk whatsoever (apart from additional brokerage perhaps)
More to come……