In exchanges with retail investors over this past summer, I have been introduced to all types of self-directed on-line traders. Many are actively using options to either generate income, hedge their long stock portfolios or even simply use Call options to speculate without buying a share of stock at all. Conversations with these folks, exchanging ideas and potential strategies warms my heart. I have also come across many investors, who while curious about using options have somehow heard “facts” about options and derivatives which have caused them to fear and avoid using options in their investing portfolios. I would like to discuss the 3 most common misconceptions I heard and bust the most erroneous myths that somehow remain out there.
The markets are rigged against small investors by high frequency traders and the small trader doesn’t stand a chance.
This theory has become more publically wide spread with Michael Lewis’ book “The Flash Boys”. In it he essentially states that ultra-fast routing technology allows high frequency traders (HFT) to buy and sell huge volume of shares across the multiple exchanges allowing them to make fractions of pennies risk free. The simple fact is that in the history of time the current securities markets have never been more open, more fair, lower cost and more advantageous for the retail ordinary investor. Bid/Ask spreads have been reduced from eighths and quarters of a dollar (0.125 -0.25) to mere pennies. Tighter more efficient markets lower the cost of trading for everyone, but especially the smaller retail traders. The key is the smaller size which retail employs, that super tight bid/ask spread is ours to take advantage of. No HFT cares about a couple hundred shares of Apple or a 5-10 lot in the options. We are not trying to scalp our stock or option purchase for fractions of a penny – we have different utility function for our trade.
Option trading is a zero sum game so either I lose or the other guy loses
This can sort of make sense on first thought. If I buy a Call and the stock increases and my position is profitable it stands to reason that the guy that sold me the call must be sitting on a loss. The reason this is not true is the diverse universe of participants in the options marketplace and more importantly the unique utility function each participant has for making that trade. Say for instance I buy a call because I am bullish and speculating that the price will increase. The seller may be looking to put on a covered call strategy, generating income on a long stock position and at the same time create a bit of downside protection. So what happens – if I am right my call increases in value and I sell it out for a profit. Great! But what about the covered call writer? He probably didn’t buy the call back from me. He may have his long stock called away from him at expiration – which actually is the maximum profit of the position! He perhaps made money on the long stock position and increased his payout by the time premium he received in the call sale. Now I certainly don’t mean to convey that all trades are winning trades for everyone but if stocks increase in value over time there is a creation of wealth in the securities markets and the derivative options trader may be using options to change the risk profile of straight stock ownership either by generating income (selling options) or employing leverage (buying options).
Selling options is risky and 80% of all options expire worthless so they are never worth buying
This 3rd misconception has two parts but when I hear someone spout off the second part – that 80% of options expire worthless, I get angry! This couldn’t be more wrong! I will de-bunk the second part first. The statistic itself may actually be correct but only with this qualifier and saying it this way. At EXPIRATION only 20% of the REMAINING EXPIRING month OPTION open interest will be EXERCISED into STOCK. That is definitely not the same thing as saying 80% of options expire worthless. Why is this the case? Because if an option is in the money nearing expiration the long holder if they decide that they don’t want stock SELL to CLOSE their long option likely at a profit! Many long option traders are employing leverage and have no intention of exercising their rights into long or short stock (calls or puts). If their option is in the money they will sell to close it and possibly roll it out in time to another option trade. The same result occurs for short option positions. If they become in the money and are threatened to be assigned, the short seller of the option – again dependent on the utility function of the trade may choose to BUY to CLOSE the position and again may roll to a new short position. Options are such powerful financial instruments that many investors do not want to lose an option position for stock and they control that by closing in the money option positions. Out of the money positions are not a threat to become a stock position so they are typically left to expire worthless. This is why that statistic of 80% expire worthless is so misleading!
Let me address the first part of this misconception now, first by saying options involve risk and are not suitable for all investors. From the Option Clearing Corporation’s Option Disclosure Document (which is required to be delivered to every account prior to approval for option trading) it states “An option holder runs the risk of losing the entire amount paid for the option in a relatively short period of time.” Options are risk transference instruments and when you sell an option you are assuming risk the option writer may be assigned an exercise at any time and be forced to fulfill the terms of the contract in exchange for the premium received. However using options responsibly, again going back to the utility of the trade, can increase your probability of profit. Looking for example at the long stock holder. Say he is long 100 shares of XYZ stock priced at 50 dollars. If he overwrites a 55 strike call option he will be obligated to sell stock at 55 (a 10% profit) and he receives a premium of 1 dollar. He is taking on the risk of missing out on further upside potential profits should the stock appreciate higher. However, he is lowering his cost basis in the stock by 100 dollars, from 5000 to 4900. When employed properly, selling options doesn’t necessarily increase your risk of stock ownership, but rather can be used to generate income from a stock position you own by assuming an obligation to do something you would want to do anyway – namely selling your long stock for a 10% higher price! You can even use a short option strategy to generate income on stock you don’t currently own but wish to buy in the future. This strategy is called the cash secured put sale. E.G. if you wanted to buy XYZ stock at a discount to the current price you could sell the 45 strike put and receive a premium today to take on the obligation to buy stock but at the price which you picked! Of course you will not actually buy the stock unless, at expiration, the share price falls below the put strike you sold – but in either case you keep the premium you collected initially.
Hopefully this article will empower you to help me in debunking these misconceptions if you hear them quoted as facts at a barbeque this weekend! With the technology available from online firms like OptionsHouse the playing field has been leveled for retail investors. Trading in the stock and option listed markets has never been fairer or at a lower bid/ask cost. Derivatives are financial tools available for all stock investors to change the risk profile of straight stock ownership. For a more detailed explanation of three basic option strategies for stock investors I invite you to view our on-demand educational webinars available here:
Stock Replacement Long Call:
Cash Secured Put:
The above information is provided by OptionsHouse for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Results may vary with each use and over time. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.