I came across a website the other day that is made up of lists. The site is a compilation of top 25 lists (list25.com). This is a great site if you are looking for ways to pass the time – on your own time of course. There are lists like “25 Crazy Facts about Sharks You Can Sink Your Teeth Into,” or “25 Amazing Facts About Your Heart That Are Hard to Beat.” The one that caught my attention was “25 Popular Myths Debunked” by David Pegg on November 8, 2011. I cannot attest to the validity of the content, but it was a fun read. Here are just a few of the Myths that are tackled on the list:
- Vikings had horns on their helmets
- Irregardless is not a word
- Dogs sweat through their tongue
As I was perusing the site, I thought I would type in “Trading Myths” just to see if there was anything listed. The search returned “The top 25 reasons why we couldn’t find what you were looking for.” Naturally, I started thinking about what I would put on a list of “Top 25 Trading Myths.”
I would have to begin with my personal favorite:
“90% of all Options Expire Worthless.”
As the Director of Options Education at Market Traders Institute, I hear this one all of the time. It is a mantra for some… “You can’t make money in the options market unless you are selling options first!” When I ask them why they believe that to be the case, they regurgitate the myth “because 90% of all options expire worthless, that’s why!” This statement tells me a bit about their depth of knowledge. I actually appreciate students that carry this belief because once I dispel the myth, that student typically becomes more teachable. The truth of the matter is that approximately 90% of all options go unexercised, but this is very different from being worthless.
Why is this an important concept to understand as an option trader? It is all about risk. As an option trader, you have the ability to begin a trade as a buyer or as a seller. Option buyers have unlimited profit potential and limited risk. Those who choose to initiate trades from the seller side have limited profit potential and unlimited risk. Given those two choices, most people would choose to initiate from the buyer side. Unfortunately, there are a growing number of uninformed option traders that believe that you can only make money trading options if you take on extraordinary risk. This belief is born from the “90% of all Options Expire Worthless” myth.
Let’s set the record straight. 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 CBOE goes on to point out that having an option expire worthless says nothing about the profitability of the strategy that it may have been part of. Multi-legged strategies can often require that one leg or more expire worthless although the strategy as a whole is profitable. https://www.cboe.com/Advisors/knowledge/myth1.aspx
When I explain to students how to trade the most basic options strategies of buying calls and buying puts, one of the instructions that I give is to sell out of the positions two weeks prior to “expiration Friday.” The reason I suggest to close the positions prior to expiration is that the value of an option is made up of two components: intrinsic value and time value. Time value, by its very nature, decays. This time decay happens to deteriorate at its fastest rate in the last two weeks of the option’s life. In order to avoid this accelerated deterioration, we close our positions early. Here is the point: closing out of profitable long calls or long puts positions prior to expiration does create a situation where the option goes unexercised, but it does not mean that the option is expiring worthless.
There are a number of option buying strategies that can be extremely profitable while helping to minimize risk. You do not have to be a seller of options to be profitable. If you are considering trading options, and you have been told that the only way to make money is by selling options, you should consider listening to someone else.
By Christopher Irvin, Market Traders Institute, Inc.