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Unlimited Risk What It Is How It Works Example

Unlimited Risk What It Is How It Works Example

Unlimited Risk: What It Is, How It Works, Example

What Is Unlimited Risk?

Unlimited risk refers to potential unlimited losses on a trade or investment.

In practice, unlimited risk can result in total loss or bankruptcy. Positions with unlimited risk can be hedged using other market instruments.

Key Takeaways

– Unlimited risk involves trades or investments that can face unlimited losses.

– Selling naked calls is an example of unlimited risk.

– While risk can be unlimited, investors can mitigate much of the risks.

Understanding Unlimited Risk

Any time an asset’s price can move against a trader’s position indefinitely, they face unlimited risk. A short trade is an example of a strategy with unlimited risk. Although unlimited risk trades theoretically have no limits, traders can take steps to limit actual losses by hedging or setting stop loss orders.

Unlimited risk is the opposite of limited risk. With unlimited risk, investors have the potential to lose more than their initial investment, as seen in short selling, trading futures contracts, or writing naked options.

Risk refers to the probability that an investment’s actual return will differ from the expected return. It ranges from losing some of the investment to potentially losing the entire amount. With unlimited risk, it is possible to lose many times the original investment.

Risk varies among investments, and one way to assess it is by calculating the standard deviation or average returns of a specific investment. A higher standard deviation indicates a higher level of risk.

Although the process may be intimidating, investors make high-risk investments regularly for various logical reasons. The main justification is that, in finance, the greater the risk, the greater the potential return. The higher potential return compensates for the additional risk taken on by the investor.

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Controlling Risk and Unlimited Risk

Unlimited risk might make certain trades or investments seem worthless. For instance, some traders may avoid short selling due to its theoretically unlimited risk. However, in reality, risk is not unlimited unless a trader (and their broker) allows it.

A trader can enter a short trade in a stock at $5 and decide to close it if the price moves up to $5.50. In this case, their actual risk is $0.50 per share and not unlimited. The price could gap above their stop loss price of $5.50, reaching $6 or $7. This would increase the loss, but it would still be limited to $1 or $2, triggering the stop loss.

The same concept applies to futures contracts or writing naked options. When losing money, a trader can close the trade, and the price at which they close it determines their actual loss.

In some cases, the loss may exceed the trader’s initial investment or even their account balance. This situation is known as a margin call, and the broker will request funds to maintain the position or zero out the account. If the trading account falls below zero due to a trading loss, the trader owes a debt to the broker.

Example: Unlimited Risk When Writing Naked Options

Suppose a trader wants to write naked calls on Apple Inc. (AAPL). The writer will receive the option premium as their maximum profit. If the price of AAPL stays below the strike price at the option’s expiry, the writer keeps the premium as profit.

However, if the price of AAPL rises above the strike price, the option writer faces theoretically unlimited risk. They have agreed to sell shares of AAPL at the strike price, regardless of the market price at that time.

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For instance, if one call option is written with a strike price of $250, which expires in three months, and the current price of AAPL stock is $240.50, the writer sells the option for $6.35. This means the writer receives $635 ($6.35 x 100 shares for one contract).

If the price of AAPL stays below $250, the writer keeps the $635 or a portion of it if they close the position early.

If AAPL rises above $250, the writer faces unlimited losses, but they can still control the loss to some extent. For example, if AAPL rises to $255 before expiry, they may decide to cut their losses and exit the options trade.

If the price of AAPL is trading at $255 at expiry, the writer has not lost money yet. They can buy AAPL for $5 above the strike price ($255) to sell it at the strike price ($250). They lose $5 there but made $6.35 on the option, so they still profit $1.35 per share, less fees.

If the price of AAPL is trading at $270 at expiry, the naked option writer has lost money. They need to pay $20 more than the strike price ($270 – $250) to sell the shares at the strike price ($250). They lose $20 but made $6.35 on the option sale, resulting in a loss of $13.65 per contract. The theoretical loss was unlimited, but the actual loss was $13.65 per contract. This loss could potentially be reduced through stop losses, exiting early, covered call strategies, or hedging.

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