By: Steve Smith
Last week I discussed the myth that 80% of all options expire worthless, which causes many options traders to forgo one whole side of the trading equation. Namely, buying options.
This week I want to pull back a bit and discuss some of the broader and more general myths that persist and prevent people from participating in option trading.
1) Options are too complicated for most traders.
It is true you can use options in complex strategies requiring a lot of experience to fully understand. It is true professional traders may choose to become quite involved with both simple and advanced math.
However, options can be used in very simple strategies involving no math at all. And beyond that, options are very easy to understand. In fact, the chances are that every reader has probably used options outside the investment arena. Do you buy insurance on your car, home, or personal property?
That insurance policy is very similar to the put options 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 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.
2) Options are only used by speculators.
It is true 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 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 short options or a seller of premium.
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 lost on losing trades. Why does this happen? When someone has a winning trade, or several winning trades, there is a tendency to believe one has discovered the path to being an accomplished and profitable trader.
Another problem is that the rookie options trader is often exposed to promotional hype on the Internet. We have all seen the advertisements mentioning 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 the hype artist’s list of winning trades is accurate – so far as it goes.
But you also need to ask whether the marketing material is neglecting to mention the losing trades.
4) Options are too expensive
When you buy options, hoping \ the stock price will work wonders for your purchase, there is an excellent chance the options will lose value and your trade will result in a loss. One of the reasons this happens so frequently is that option buyers tend to purchase options that eventually expire worthless. And, when your options expire worthless, it is easy to believe 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 are impacting the options pricing in the marketplace. I hope you already recognize option prices are not arbitrarily set and the market makers know what they are doing when establishing bid and ask prices for each option 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 it is wrong to believe options are always “too expensive.” One good rule is to generally avoid buying out-of-the money options because they are “dollar” cheap.
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 you don’t believe the profit-destroying myths.