Perils Associated With Day Trading Stock Options

Day trading has between a 5-30% statistical chance of success according to market observers and financial analysts. The North American Securities Administrators Association (NASAA) has reported 70% of stock day traders lose all their capital through day trading. (1)

Risk alone is a major peril of day trading stock options. The reasons why day trading stock options is risky, especially to those unfamiliar with the practice, is lack of know how, the debt leveraging involved in day trading stock options, and the unpredictability of the market in general.

• Complexity of options rules

The actual process of day trading stock options is a peril because of the complexity and attention to detail that rapidly changes with fluctuations in market conditions. Moreover, risk management methods vary with the financial instrument, industrial sector, investment type etc., and a new technique may be needed for each trade depending on what is most financially suitable for the market. Properly learning how to day trade stock options can have positive results on the probability of success, but this isn't necessarily easy. However, those who are able to learn how to day trade mostly do not lose money as confirmed in a U.S. Securities and Exchange Commission (SEC) report that quotes the Electronic Traders Association (ETA).(2)

• High capital investment

According to the Financial Industry Regulatory Authority (FINRA), day traders who do so more than 4 times in one week with more than 6% of their trading capacity are subject to a minimum stock reserve of $25,000.(3) This is a large amount of liquid capital that can incur opportunity cost and risk of its own.  For example, if the $25,000 consists of the majority of the day traders net capital worth, and the aforementioned day trading risks apply, then that day trader is putting a large amount of their financial security at risk.

• Margin calls, commissions and fees

Another peril of day trading stock options are the costs of day trading. Since day trading involves frequent buying and selling, transaction commissions and fees can add up fast. If those transactions do not yield a profit in excess of the commissions and fees, not only has the option day trader lost money, but time as well.

Options contracts are usually based on cost per 100 shares not including broker commissions and generally cost more per contract when the perceived chance of success is higher. For example, an option to buy 10 option contracts to sell British Petroleum before January 2012 might cost  $38.80 per contract at a share price below $70.00 but only $3.50 at a share price below $17.50.(4)

• Increased stress

A fourth peril of day trading stock options is the stress. The U.S. Bureau of Labor Statistics (BLS) sites professions in Securities, Commodities and Financial Services Sales to be among the more stressful.(5) In the case of retail stock option day traders, this follows by extension as the amount of money that can be gained or lost in a matter of moments is large making the threat of bankruptcy, massive debt and great loss of financial stability real.

In summary, the perils of day trading stock options are considerable and worth paying attention to if sound financial planning, and a relatively stable life are of interest. The potential loss, stress, costs, time and risks involved in day trading stock options are significant perils that make it less of an easy money scenario, and more of a high stakes, time consuming and complex series of tasks that repeat themselves several times per week.

Sources:

1. http://bit.ly/cjZBLs (NASAA)
2. http://bit.ly/bHsmy5 (Securities and Exchange Commission)
3. http://bit.ly/9PzpRD (FINRA)
4. http://yhoo.it/cTv1Gp (Yahoo Finance)
5. http://bit.ly/9sFnOT (Bureau of Labor Statistics)

The Dynamics of Systemic Risk in Financial Markets

Systemic risk can occur anywhere within and without a financial system where that risk can cause negative consequences for an industry, economic sector and financial system.(3) An example of systemic risk is the credit default swaps that were so poorly managed and regulated, they contributed heavily to the financial crisis of 2008-2009.(4) These credit default swaps overestimated the reliability of sub-prime mortgages and the insurance companies that protected investments in large portions of these repackaged mortgages.

• Types: of systemic risk

Systemic risks can affect the financial solvency of institutions such as banks or it can affect the capacity of an industry to produce at sustainable levels. A systemic risk can also include poor risk management that given certain circumstances would fail to preserve the financial strength of the business(es) that risk management aims to protect. Low cash reserves per aggregate debt risk, or inadequate engineering standards on a large production line are also examples of systemic risk. According to a keynote speech to the Federal Reserve Bank of Atlanta, failure of adequate government regulation is also considered a systemic risk. (3)

• Exposure to systemic risk

Exposure to systemic risk is manageable to an extent. Very few risks if any can be prevented from occurring 100 percent of the time. Depending on the industry, regulation of that industry and the management of specific businesses, exposure to systemic risk can vary. For example, in the production of nuclear energy, because systemic risk is so dangerous if not prevented, the exposure to risk is much more heavily regulated than with businesses that have less of an overall impact nationally even if the collapse of those businesses could cause problems for a financial market.

• Methods of avoiding systemic risk

Systemic risk can be avoided by regulation of financial transactions that are known to be very risky. Complex financial derivatives or leveraged assets that's value depends on other assets can be a systemic risk if proper risk controls are not in place to avoid excess investment in such products under potentially perilous financial conditions. According to Ben Bernanke, Chairman of the U.S. Federal Reserve Bank indicates the financial help of government plays a role in preventing the greater impact of systemic risk, however he also states, a useful set of laws and actionable practices can prevent the systemic risk from being as threatening to financial markets. (1)

• Probability of systemic risk

The probability and potential affect of systemic risk is measured using statistical and economic formulas. The statistical value 'Beta' in addition to correlation data is a measurement that can be used to ascertain systemic risk.(5) If the outcome of these formulas leads to a valid probability of a particular systemic risk being realized, then the possible impact of that risk is measured to assess how to better control against that risk. 'Stress tests' are an example of probability and affect estimation, however, if the tests themselves do not account for enough systemic risk, then the threat of systemic risk on financial markets is underestimated.

• Magnitude of systemic risk

How much of a problem systemic risk has on financial markets can vary. Just because a business or industry has systemic risk, doesn't necessarily imply the harm caused by that risk will be worth the cost of prevention.(2) Thus, the cost basis of risk management is an important aspect of financial markets because businesses and/or governments that fail to adequately control systemic risk for the sake of profits, can have an impact on financial markets. This is especially so if they are very large oligopolies linked to other industries. Systemic risk can cause job losses, bankruptcy, industry lackluster and financial ripple affects within businesses and in the economy.(1)

Sources:

1. http://bit.ly/1roDYq (Federal Reserve Bank)
2. http://bit.ly/a6B7sU (NY Fed)
3. http://bit.ly/OaGxg (Taylor)
4. http://bit.ly/bAbrNg (U.S. Government Accountability Office)
5. http://bit.ly/blESQ7 (National Bureau of Economic Research)