Misconceptions hound the option market and those who’d like to elevate their trading to include option contracts. Taking that first step often hinges on shedding these four myths.
Options are often misunderstood. According to the infomercials on Saturday morning television, there’s even a secret formula that Wall Street doesn’t want you to know about. Of course, that’s not exactly true. But neither are some of the most common misconceptions about trading options. I’ll save you the hassle and the $19.99 (plus shipping and handling) and expose four of the biggest myths surrounding options.
Naysayers will also tell you that trading options is risky, complex, unnecessary … even rigged. Well, I’ve been told the same thing about the stock market, too. Options do require a higher level of trading knowledge than basic stock investing. In fact, options trading involves more risk, and more complex risk, than trading stock.
Options were originally designed to manage risk. The element of leverage makes options a potentially attractive hedge for a portfolio or as relatively low-cost speculation. Just like any investment, a trading decision can be made more risky or more conservative depending on how you execute the strategy. A wise option trader knows the potential risk and reward of each trade, as well as the probabilities of success. Education is the key.
Interestingly, this myth is used by people on both sides of the argument. On the one hand, it’s used by critics as proof that buying options is essentially a fool’s errand. On the other hand, it’s used by misguided promotors to suggest that selling options is the only way to succeed. Both are wrong.
According to the Chicago Board Options Exchange (CBOE), approximately 90% of options go unexercised. That’s very different from being worthless. Of that 90%, around 60% of option positions are closed prior to expiration, while the remaining 30% expire worthless. None of these statistics speaks to the profitability or purpose of the strategy. For example, many multi-leg option strategies require the use of a protective option that is expected to expire worthless when the strategy is profitable.
Along the same lines as myth #2, this fable assumes every trader has the same objective when buying or selling an option contract. In other words, one side must win while the other loses. They don't always have the same objective, perhaps one is speculating on direction and the other is hedging a stock position. That means there are plenty of situations in which two traders will both hit different goals using the same transaction.
One way to think of option trading is as managing risk. One side is compensated for taking on the risk of the other, and that's something we do in every economic decision we make.
This isn’t so much a myth as it is an excuse. Just like any worthwhile endeavor, it takes some effort to learn about the options market, but it’s not difficult to begin. Consider options as an extension of your stock investing strategies. Own a stock that you’re thinking of selling? Learn the basics of a covered call strategy. Want to commit yourself to buying a stock? Explore the slightly more advanced cash-secured put strategy, or if you have a higher risk tolerance and you already consider yourself fluent in options, considering selling a naked put. Interested in the ability to sell a stock you hold, at a known price, even if the stock falls, at least over a short period of time? Investigate the workings of a protective put.
As you learn the dynamics of how options work over time, you may some day combine basic concepts into more complex strategies. The goal is to master a few simple, purposeful option strategies and explore if they have a role in your overall investing playbook before moving on to the more complex.
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A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received.
The cash secured put strategy risks purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower.
With the protective put strategy, while the long put provides some temporary protection from a decline in the price of the corresponding stock, this does involve risking the entire cost of the put position. Should the long put position expire worthless, the entire cost of the put position would be lost.
The naked put strategy includes a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower. Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.
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