Debunking the Options Trading Myths
There are a lot of myths surrounding options trading. The options, by themselves, are not dangerous tools. The only dangerous part of options trading is the risk-insensitive trader who buys and sells options with little or no understanding of just what can go wrong.
- This is the First Guest Post on OptionAutomator. Thank you to Kim Klaiman of SteadyOptions
- 8 Options Trading Myths That Need Debunking
- How to avoid the dangerous pitfalls in options trading.
There are a lot of myths surrounding options trading. The options, by themselves, are not dangerous tools. The only dangerous part of options trading is the risk-insensitive trader who buys and sells options with little or no understanding of just what can go wrong. Options can be used for speculation, but also for hedging, protection, leverage etc. There is more than one way to make money with options. Here are some of the common myths and misconceptions about options trading.
Myth #1: Trading Options is only for Professionals
Options were always a tool available to investors, but they were not as widely adopted because there was no supporting technology to help the industry. Then came the first online trading platform which brought the trading technology the pros were using to the general public. Since then, technology has improved exponentially and retail trading has started to be adopted by the masses.
What was true maybe 10-15 years, is not true today, due to technology changes, reduced broker commissions etc. For example, many brokers today charge less than $1 per contract to place an options trade. This is way less than it used to be just few years ago.
Myth #2: Options are for speculation only
The truth is that options can be used in many ways. For example:
- An investor can buy protective puts to hedge his stock before a major event like earnings.
- An trader who believes the market will be range-bound, can trade mix of income producing strategies, like iron condors, calendars etc.
- An investor who wants to buy a stock at discount can use a naked put strategy.
- A covered calls writer who wants to protect himself from an unexpected sharp drop in the price of the stock can use a collar strategy.
Myth #3: You can only profit by buying calls or puts
This is a very common misconception. While it is true that buying calls or puts can be very profitable, it is also a more risky way to trade. When you buy calls or puts, you have to be right three times:
- Direction of the move.
- Size of the move.
- Timing of the move.
The underlying asset has to move in the right direction. You can predict the direction and the size of the move, but if the move happens after the options expired, you lose money. Even if everything works in your favor, but Implied Volatility collapses (after earnings for example), you might still lose money.
Myth #4: Selling naked puts is very risky
Did you know that selling naked puts has the same P/L profile as selling covered calls? Yet most brokers allow traders to sell covered calls in their IRA accounts, but not naked puts? I find it extremely ignorant. An alarming number of financial professionals, including stockbrokers, financial planners and journalists are in position to educate the public about the many advantages to be gained from adopting naked put writing (and other option strategies), but fail to do so. Many public investors never bother to make the effort to learn about options once they hear negative statements from professional advisors.
Writing naked put options is a significantly more conservative strategy and definitely less risky than simply buying and owning stocks. As such it deserves to be considered as an attractive investment alternative by millions of investors.
Myth #5: 80% of options expire worthless
According to The Chicago Board Options Exchange (CBOE) here are the facts:
- Approximately 10% of options are exercised (The trader takes advantage of their right to buy or sell the stock).
- Around 55%-60% of option positions are closed prior to expiration.
- Approximately 30%-35% of options expire worthless.
The simple fact is that number of options expiring worthless means nothing. It doesn't mean that when you buy options, you automatically have 70% chance of winning, it also doesn't mean that if you write options, you only have 30% chance of winning. For example, Multi-legged strategies can often require that one leg or more expire worthless although the strategy as a whole is profitable.
You can read more here.
Myth #6: Only options sellers make money
The truth is that both option sellers and buyers can profit from trading options. If only sellers made money, there would be no buyers. With no buyers there would be no market. While selling options does have an edge in many cases, it also exposes you to negative gamma.
Premium buying is the less-traveled road, but it can be profitable for the well-prepared, disciplined trader. In fact, no strategy is better or worse than other. There is more than one road to Rome.
Myth #7: Trading options is a zero-sum game
The truth is that options may be used as insurance policies or risk management tools, not only trading vehicles.
As Mark Wolfinger explains here: "If I buy a call option and earn a profit by selling at a higher price, there is no reason to believe that the seller took a loss corresponding to my gain. The seller may have hedged the play and earned an even larger profit than I did. I don’t see anything resembling a zero sum game in hedged options transactions. I understand that others see it as black and white: If one gained, the other lost. But that’s an oversimplification."
- There are many ways to trade options.
- Position sizing is a key to successful trading.
- Few small winners achieved with low risk might be better that one big winner achieved with higher risk.
- Selling naked puts might be actually less risky than trading a stock.
- What is really important is not an occasional big winner, but an overall portfolio gain.
The key to success in options trading is using mix of diversified options trading strategies, like straddles, calendars, iron condors etc. In my opinion, you can rarely succeed in options trading by buying some cheap out of the money options and “hoping” for a big move.