By: Steve Smith
One of the persistent and pernicious myths regarding options is that 80% of all them are worthless. The number belies the fact that most options get closed well before expiration and can create some misleading beliefs that selling premium is the only sure way to make money trading options.
We’ve all seen the marketing emails and promotional literature that tout 85% win rates and push the concept that selling options allows you to “become the house” in the great option casino analogy. While I firmly agree that there are distinct advantages to being a net seller of premium, such as the tailwind of time decay and a statistically higher probability of realizing a profit, I think those benefits need to be kept in perspective.
It’s true that most professional traders prefer positions with a positive theta it’s important keep in mind they are usually actively hedging to maintain a non-directional delta neutral portfolio; meaning they must have time decay on their side if they are to make money.
But unfortunately, the professionals approach, along with the myth that 80% off options expire worthlessly has led many retail traders, especially newcomers, into the false belief that buying options, or using debit strategies is for suckers only. In both cases, nothing could be further from the truth.
The reason the 80% myth persists and is presented as truth is that only 10% of option contracts are exercised. That is true. But from there can we make the leap that 90% expire worthless?
If we did, we would be ignoring the 60%-65% of option contracts that are closed out prior to expiration. Remember, an option contract is only created when there is both a willing buyer and seller. During the course of any given expiration cycle the majority of contracts created, which at some point translates into current open interest, gets closed.
This is done by both those who initiated the trade as a seller — they look to buy back and close positions at a lower price — and those that initiated buyer positions and look to close by selling at a higher price. By the time any Friday expiration comes around, the majority remaining open positions are indeed out-of-the-money, and left to expire worthless. But that doesn’t tell the whole story.
In the end, the options market is a closed system and a zero-sum game and during the course of any expiration cycle, those that initiated positions as buyers probably reap an equal amount of profit, or incur similar losses, as those that initiated trades as a seller or “collector” of premium.
The main difference is options sellers or credit positions tend to have a higher win rate but a lower rate of return. Meaning buying options might not produce the same consistent profits but offers more attractive risk/reward profiles.
This is incredibly important for retail investors that want to employ options and the more efficient use capital that their leverage affords to make directional bets. The negative impact time decay on a debit position can be greatly reduced by buying options with 60 days or more until expiration or employing spreading strategies.
All told, maybe some 30%-35% of all option contracts created, ultimately expire worthless. Not an insignificant amount, but far from the “house” odds often touted for can’t-miss income streams.
So don’t let the myth preclude you from taking advantage of buying options when the proper set up presents itself. You’ll be able to take profits well before they ever get close to expiring worthless.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.