By: Steve Smith
Nearly all of Options360 trades come in a type of spread. I believe it’s crucial for positions to have some element of premium collection in order to generate consistent returns.
\However, a persistent and pernicious myth regarding options is that 80% of all options expire worthless. The number belies the fact that most options get closed well before expiration, and can create a misleading belief that selling premium is the only way to make money trading options.
We’ve all seen the marketing emails and promotional literature touting 85% win rates, pushing the concept that selling options makes you “the house” in the great option casino analogy. While I firmly agree that there are distinct advantages to being a premium net seller, such as the time decay tailwind and a statistically higher probability of profit realization, I think those benefits must be kept in perspective.
Although it’s true that most pro traders prefer positive theta positions, it’s important to remember that they’re usually actively hedging to keep a non-directional delta neutral portfolio; they must have time decay in order to profit.
But, unfortunately, the professional approach, along with said myth (80% of options expire worthless) led many retail traders, especially newcomers, to falsely believe that buying options or using debit strategies is only for suckers. In both cases, nothing is further from the truth.
The reason for the 80% myth and it’s presented as truth is because only 10% of option contracts are exercised. That’s true. However, from there, we can leap that 90% expire worthless?
If we did, we’d be ignoring 60%-65% of option contracts that are closed out before expiration. Remember: An option contract is only created when there’s a willing buyer and seller. During any expiration cycle, most contracts created — that eventually translate into current open interest — get closed.
This is done by those who initiated the trade as a seller, looking to buy back and close positions at a lower price, and those that initiated positions as buyers looking to close by selling at a higher price. By the time any Friday expiration comes around, most of the remaining open positions are 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. During any expiration cycle, those that initiated positions as buyers likely reap an equal amount of profit, or incur similar losses, as those that initiated trades as a seller or premium “collector”.
The main difference is options sellers or credit positions tend to have higher win rates but lower return rates. Meaning, that buying options may not produce the same consistent profits, but offer more attractive risk/reward profiles.
This is incredibly important for retail investors looking to employ options and the more efficient use of capital that their leverage affords to make directional bets. The negative impact of time decay on a debit position can be greatly reduced by buying options with over 60 days until expiration or employing spreading strategies.
All told, maybe some 30%-35% of all option contracts ultimately expire worthless. Not an insignificant amount but far from the “house” odds often touted for can’t-miss income streams.
Hence, don’t let the myth preclude you from taking advantage of buying options when the proper setup presents itself. You’ll be able to take profits well before they ever get close to expiring worthless.