Option Myths

Separating Truth from Fiction

Mythology
Mythology. Google Images

Many articles and some books have been written on a single topic: Debunking myths. Because it is often difficult to get some people to ignore myths -- even myths that are easy to prove false -- the option world is misunderstood by a large portion of the population. Despite proof that certain beliefs (old wive's tales) are incorrect, people who "fear" options cannot be educated. So be it.

To readers who currently believe that learning how to use options is a waste of time, I hope to convince you that the following statement is true:

Options are risk-reducing investment tools that can be used by the vast majority of long-term, or short-term, investors and traders to accomplish two items on every trader's wish list:

Trade with less money at risk.

Increase the chances of earning money with every trade.

A Few of the Many Myths

1. Options are too complicated for most traders.
It is true that you can use options in complex strategies that require a lot of experience to fully understand. It is true that professional traders may choose to become quite involved with both simple and advanced math. However, options can be used in very simple strategies that involve no math at all. And beyond that, options are very easy to understand -- as a discussion of the most basic concepts of options illustrates.

In fact, the chances are that every reader has probably used options outside the investment arena. Do you buy insurance for your car, home, or personal property?

That insurance policy is very similar to the put options that are traded at the CBOE or other option exchanges. Have you ever received a rain check from a retail store or used a discount coupon that arrived in the mail or that you found in a newspaper? Those items are very similar to call options.

Thus, if you understand why people buy insurance policies and that the cost of such insurance varies, depending on conditions, then you already understand how put options work.

If you understand that owning a discount coupon does not obligate you to utilize it to purchase the product (underlying asset) -- but gives you the choice of doing so --  then you understand how to use call options. Here is a more detailed explanation of insurance policies and rain checks.

2. Options are only used by speculators.
It is true that speculators and gamblers use options. But that has nothing to do with you or me. Options were designed to mitigate risk. in other words, options were created as a tool for shifting risk from people who wanted to avoid taking risk, to those who were willing - for a price - to accept risk.

In today's investment world, if a stockholder who wants to maintain ownership of his/her shares decides that the current, or future, stock market is temporarily in a dangerous place, that investor can hedge the position by buying put options. The investor pays cash for those puts and thereby limits losses. In turn, the person who sold the puts collects the cash premium and in return assumes the risk associated with being short put options.

The original put buyer transfers downside risk to the put seller. That put seller may be willing to assume that risk without any risk reduction or he may decide to limit his exposure to loss by buying or selling other options to other risk takers.

This is essentially an endless process whereby risk is transferred.

The point for you is that it makes no difference with whom you trade or the reason why that other party was willing to make the trade. You can adopt any of numerous option strategies that allow you to take as much or as little risk (in this discussion, risk is defined as the amount of money that can be lost) as desired. And that is why options are risk-reducing tools that can also be used by people who want to take additional risk.

3. It's easy to make money when trading options.
There is a little bit of truth to this statement. Yes, often it is easy to make money from options trading. Unfortunately, it is even easier to lose money when trading options. Too many novices fall into the trap of getting excited when they earn money on any given trade and tend to forget (or intentionally ignore) the cash that is lost on losing trades.

Why does this happen? When someone has a winning trade or several winning trades, there is a tendency to believe that one has discovered the path to being an accomplished and profitable trader. That novice mind does not recognize that everyone has some profitable trades, along with some unprofitable trades.

Another problem is that the rookie options trader is often exposed to promotional hype (i.e., bullsh**) on the Internet. We have all seen the advertisements that mention how much money has been earned on each of a series of trades -- and that type of promotion is quite successful in attracting inexperienced traders who believe the hype and fail to ask questions. The chances are quite good that the hype artist's list of winning trades is accurate -- so far as it goes. The downside is that this hypester neglects to mention the losing trades -- which often lose more money than was earned with the winning trades. Here's my take on this: If you want to reach out to anyone who advertises great results, ask two vital questions: 1) Does your trade list include every trade -- both winners and losers? And 2) Have your results been audited (i.e., Was there an official inspection of your books, preferably by an independent body? Never trust un-audited results.

4) Selling options is the best way to make money because 90% of options expire worthless.
This is one of those false beliefs that never goes away. The truth is that only about 20% of options expire worthlessI believe that option-selling strategies work out better over the long term for disciplined traders who know how to manage risk. However, there are many people who are unsuited to the option-selling game and who are much better served by adopting an option-buying strategy. The important point is to understand the benefits of each strategy and know which, if any, are compatible with your comfort zone and tolerance for risk.

5) Options are too expensive.
When you buy options, hoping that the stock price will work wonders for your purchase, there is an excellent chance that the options will lose value and that your trade will result in a loss. One of the reasons that this happens so frequently is that option buyers tend to purchase options that eventually expire worthless. Ans, when your options expire worthless, it is easy to believe that you paid too much money for them. That is not always true.

Before trading options, it is necessary (if you have any expectation of earning money from your trading) to understand which factors affect the price of options in the marketplace. I hope that you already recognize that option prices are not arbitrarily set and that the market makers know what they are doing when establishing bid and ask prices for each option that is traded.

It is important to understand one more factor that goes into the price of options: supply and demand. Market makers may set their prices when the options first begin trading, but after that, when there is an influx of buy or sell orders, then option prices move higher or lower -- until an equilibrium is found. In other words, the markets are adjusted with the intention of equalizing buy/sell demand.

The bottom line is that option prices are sometimes quite low (compared with a theoretical value) and at other times they are too high. But is is wrong to believe that options are always "too expensive." The marketplace generally sets option prices to where they should be. If you believe the myth that prices are too high most of the time, then I encourage you to take the time to learn about the importance of the factors that affect an option's price.

Warning; Do not make a habit of buying options that are far out of the money just because they seem so cheap. It is often those inexpensive looking options that are the most over-priced.

6) Covered call writers should buy stocks with the most expensive (i.e, highest premium) options so that their profit will be as large as possible.

This is one of those false beliefs that is very costly to novice traders. In my opinion, the most important consideration for anyone who wants to write covered calls (or adopt the equivalent strategy of writing naked puts), is stock selection. And the factors that go into choosing an appropriate stock include: a stock that you have followed, researched and decided that you want it to be part of your investment portfolio. Because your plan is to write options, it is important that the option premium is adequate to make the strategy worthwhile -- and "adequate" does not translate into "as high as possible."

Why is that important? Option markets, like other financial markets, are rational for the vast majority of the time that they are open for trading. In other words, when option premium is high -- and especially when it is "almost too good to be true" -- there is a good reason for that high premium. It means that the stock is volatile and the stock price is expected to trade in a wide price range -- based on the fact that its price action has been volatile in the past. Sometimes the premium becomes quite high, and attractive to sell, even when the stock is usually not very volatile. This occurs when news is pending -- an earnings report, an FDA announcement about a drug trial, or a big election where the outcome is not known in advance (think the June 2016 Brexit vote).

When stocks are volatile, there is an equal chance that its price will move higher or lower. If the price soars, that is good for the covered call writer who earns the maximum possible profit for the trade (getting when expiration arrives). However, when the price of the volatile stock declines, there is a very good chance that the price will fall so far that the premium collected (when selling the option) will not be anywhere near large enough to offset the loss incurred when the stock price tumbled. That is the risk.

If you are a conservative trader or one who is willing to take some risk for an enhanced reward, writing covered calls is a reasonable strategy. But please understand that it is very risky to seek stocks for this strategy based solely on the high premium available to the seller.

There are other myths associated with option trading. My objective in choosing those above is to try to enhance your option-trading results by being certain that you don't believe the profit-destroying myths.

I wish you good trading.