What Is Unlimited Risk?
Let me explain unlimited risk to you directly: it's a situation in trading or investing where your potential losses could theoretically go on forever. In reality, though, this often boils down to a total wipeout or even bankruptcy if things go really south. Remember, you can hedge these positions with other market tools to keep things in check.
Key Takeaways
- Unlimited risk applies to trades or investments that could theoretically rack up unlimited losses.
- Selling naked calls is a prime example of unlimited risk.
- Even with unlimited risk, you as an investor can mitigate most of it through smart strategies.
Understanding Unlimited Risk
You face unlimited risk anytime an asset's price can keep moving against your position without any upper limit. Take a short trade, for instance— that's a strategy with unlimited risk baked in. Sure, the theory says the risk is unlimited, but you don't have to let it play out that way; you can limit your actual losses by hedging or using stop loss orders.
This is the flip side of limited risk, where you could lose more than what you put in initially—think short selling, futures trading, or writing naked options. Risk, at its core, is the chance that your investment's return differs from what you expected, ranging from partial losses to losing everything or even more.
Different investments carry different risks, and you can measure it using standard deviation of historical or average returns—a higher deviation means higher risk. I know high-risk investments might seem daunting, but investors dive into them all the time for good reasons. In finance, the rule is simple: more risk often means the potential for bigger rewards to balance out what you're putting on the line.
Controlling Risk and Unlimited Risk
Unlimited risk might sound like a deal-breaker, making you want to steer clear of trades like short selling. But while the risk is theoretically endless, it only becomes truly unlimited if you and your broker let it spiral out of control.
Say you short a stock at $5 and set a rule to close if it hits $5.50—your risk is capped at $0.50 per share. Sure, the price might jump over your stop to $6 or $7, bumping your loss to $1 or $2, but it's still limited. This applies to futures or naked options too: you close the trade when it's losing, and that exit point sets your actual loss.
Losses can exceed your initial investment or even your account balance, leading to a margin call where your broker demands more funds to cover or zero out the account. If it goes negative, you're in debt to the broker—that's the harsh reality.
Example: Unlimited Risk When Writing Naked Options
Let's walk through an example with writing naked calls on Apple Inc. (AAPL). As the writer, you pocket the option premium—that's your max profit. If AAPL stays below the strike price at expiry, you keep that premium as profit.
But if AAPL climbs above the strike, you're looking at unlimited risk since there's no ceiling on how high it can go. You've committed to selling shares at the strike to the buyer, so you'll have to buy them at market price, no matter how inflated.
Suppose you write one call with a $250 strike expiring in three months, while AAPL is at $240.50. You sell it for $6.35, netting $635 for the contract. If it stays under $250, you keep the $635 or part if you close early.
If it hits $255 before expiry, you might exit to cut losses. At expiry, if it's $255, you buy at $255 to sell at $250, losing $5 but still up $1.35 after the premium. But at $270, you lose $20 on the shares minus $6.35 premium, netting a $13.65 loss per contract. Theory says unlimited, but your actual loss is what you control—use stop losses, exit early, go covered, or hedge to minimize it.
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