Some old myths about options just keep circulating, and some of them need to be debunked.
In a webinar for OptionsEducation.org, the educational arm of the OIC, instructor Todd Willemon addresses some of those myths. Among the most prevalent of those myths misinforms us that sellers of options are smarter than buyers of options since 90 percent of options expire worthless.
Not so, Willemon argues. In one of the years the OIC tested, 12 percent of the options were exercised, leaving about 88 percent or almost 90 percent unexercised. Does that mean they expired worthless? Far from it.
Only about 19 percent expired worthless. A further 69 percent were closed prior to expiration. Some of those were closed at a profit, and some were not. And, if you're new to trading options, it may surprise you to learn that some of those options that expired worthless made a profit for the options trader, and some, of course, did not. Some of those options expiring worthless were originally sold and a credit taken in and deposited in the trader's account. If that option expires worthless, the trader keeps the profit. It's that possibility that results in the myth about the option seller being smarter than the option buyer, but if only a portion of the 19 percent expiring worthless are making the trader a profit, is that myth really true?
What does it matter whether we believe this myth or not? It matters. We all want to be smart. Believing that myth can blind us to the right trade for us.
What Willemon wants options traders to know is that the strategy should be matched to the trader's skill set, goals, outlook, market conditions and trading account size. For example, a couple of weeks ago, I was noting either on this page or in a Monday Wrap that with the VIX and the RVX, the RUT's volatility index, hitting the levels that usually mark a low for these volatility indices, long options might be cheap. Implied volatility impacts the price of options. When it's low, option prices tend to be low. When it's high, those options tend to be expensive. Those who wanted to protect against or benefit from a rally or a rollover might have found that buying options was a good strategy as long as they chose the right option with the right timeframe. Since then, implied volatilities have risen. At other times, when implied volatilities are high, traders might not want to buy expensive options for hedging or directional trades. They might want to use a spread.
Another somewhat related persisting myth is that options are a more dangerous security than stocks. As many traders know, options were invented to hedge risk, to act as a sort of insurance. Farmers might want to buy a put on their product, giving them the right to sell it at a certain price, for example. They put a floor under the price they'll receive for their agricultural product.
It's true that trading options entail risks. Sometimes the risk proves to be higher than the potential reward, as is often the case in high-probability iron condors, for example. Because of this reality, it is true that trading options can be dangerous to those who don't understand the trade they've chosen. Options traders should always understand the risks they're accepting or forgo the trade. I just heard from a trader this week who had entered a trade but had no idea how to adjust it when the markets headed down. That's not a good idea. Before you enter an options trade, you should always know what you'll do if the trade goes the direction you want and if the trade goes against you. Know when your options expire. Know what your brokerage's practice is with regard to automatically exercising if a strike is slightly in the money at expiration.
However, imagine that a trader believes in the bullish prospects of a favored stock or the bearish potential in an ill-favored one and wants to participate in potential movement. Imagine further that the trader wants to risk only a certain dollar amount. Options are so flexible that they offer an opportunity to structure a trade that would benefit from the anticipated movement, if it occurs, but would also limit the risk the trader accepts. The trader who has neither the money nor the inclination to short a stock can still participate in a bearish gains if the stock rolls over, and the trader who doesn't have the funds to buy a stock can participate in that stock's rally.
Education and the matching of the trade to the trader's outlook, trading style and account size remain key, as Willemon asserts. To learn more about other options myths that need to be debunked, you can view his webinar presentation on the OptionsEducation.org website. There, he refutes other myths such as the scariness of being assigned on an in-the-money option. Sometimes we want to be assigned on an option we've sold. Want to find out why? Check the video.