By Joe Duarte

Both call and put options have risk that is limited to the initial investment. This initial investment can vary in size, but is less than the investment required to control the same number of shares of the underlying stock.

Although the risk is relatively smaller in terms of dollars, it’s important to recognize that the likelihood that an option will go to zero is much higher than the underlying stock going to zero.

The chance that an option will go to zero is 100% because an option is a limited life security that eventually expires. At expiration, the option value goes to zero unless the option, put, or call is in-the-money.

Call option

A call option gives the buyer the rights to purchase the underlying stock at the contract’s strike price by its expiration date. When the strike price for the call option is below the price for the underlying stock, it will lose time value as expiration nears. Assuming the stock remains at the same price level, this time decay can result in losses for the trader. The losses will be limited because the option retains its intrinsic value.

However, when the stock is trading below the strike price, the option’s value is all time value. Assuming the stock remains at the same price level, time value diminishes as you get closer to expiration. Continuing in this manner will result in a total loss of the initial investment.

Most of the time a stock doesn’t stand still — it does that vacillation thing. That means that although there’s a chance the underlying stock will increase in value by rising above a call strike price, the stock may also decline in value and fall below the strike price. Once again that puts you in a situation where you can lose your entire investment as expiration nears.

Put option

A put option provides the buyer with rights to sell the underlying stock at the contract’s strike price by its expiration date. The option will lose time value as expiration nears, which can result in losses for the trader when the stock is trading above the option strike price. When trading below the strike price, the losses will be limited because the option retains intrinsic value.

However, when the stock is trading above the strike price, the option’s value is all time value. Assuming the stock remains at the same price level, time value diminishes as you get closer to expiration. Continuing in this manner will result in a total loss of the initial investment.

Because the stock has the same chance of rising as falling, there’s a chance the underlying stock will increase in value rising above a put strike price. As a result, as is also the case with call options, you can lose your entire investment as expiration nears.