There is a general misconception in the trading community that option trading is very risky. Options can be risky, but they don’t have to be. Options can be less risky or more risky, depending on your risk tolerance. They can be used for speculation, but also for hedging, protection, leverage etc. There is more than one way to make money with options. Here are some of the common myths and misconceptions about options trading.
Myth #1: Trading options is a zero-sum game
The truth is that options may be used as insurance policies. They can be used as risk management tools, not only trading vehicles.
As Mark Wolfinger explains here: “If I buy a call option and earn a profit by selling at a higher price, there is no reason to believe that the seller took a loss corresponding to my gain. The seller may have hedged the play and earned an even larger profit than I did. I don’t see anything resembling a zero sum game in hedged options transactions. I understand that others see it as black and white: If one gained, the other lost. But that’s an oversimplification.”
Myth #2: It’s easy to make money with options
Here is an inconvenient truth about options trading: it’s work. Learning how to trade and invest successfully requires a lifetime of work, dedication, and focus. Not only is there a long and difficult learning curve just to learn the basic fundamentals, but you’ll soon discover that being a student of the markets never ends.
The key to finding AND maintaining a high level of success in the markets is to trade and invest according to your own risk tolerance, time horizon, investment goals, and personality. This is very important. Your #1 goal should be to develop your own approach that takes all of these things into account.
Myth #3: The only profitable way to trade options is buying calls or puts
This is a very common misconception. While it is true that buying calls or puts can be very profitable, it is also a more risky way to trade. When you buy calls or puts, you have to be right three times: Direction of the move, Size of the move and Timing of the move.
The underlying has to move in the right direction, and fast. You can predict the direction and the size of the move right, but if the move happens after the options expired, you lose money. Even if everything works in your favor, but Implied Volatility collapses (after earnings for example) you might still lose money.
Myth #4: Only 90% probability strategies make money
A lot of options traders consider 90% probability strategies a Holy Grail of trading. 90% winning ratio strategy in options usually refers to Out Of The Money credit spreads that have 90% probability to expire worthless. To achieve 90% probability, you have to sell credit spreads with short deltas around 10.
Here is the problem: when you have a 90% probability trade, your risk/reward is terrible – usually around 1:9, meaning that you risk $9 to make $1. Also with 90% probability trades, your maximum loss is usually limited to 8-10%, but your loss can be 100%. That means that you can have 90% winning ratio, and still lose money. Also consider the fact that if you win 10% five times in a row and then lose 50%, you are not back to even. You are down 25%. Winning ratio alone doesn’t tell the whole picture – in fact, it is pretty meaningless. The only thing that matters in trading is your average return per trade, not the winning ratio.
Myth #5: Selling naked options is very risky
Did you know that selling naked puts has the same P/L profile as selling covered calls? Yet most brokers allow traders to sell covered calls in their IRA accounts, but not naked puts? I find it extremely ignorant. An alarming number of financial professionals, including stockbrokers, financial planners and journalists are in a position to educate the public about the many advantages to be gained from adopting naked put writing (and other option strategies), but fail to do so. Many public investors never bother to make the effort to learn about options once they hear negative statements from professional advisors.
This is a naked put P/L diagram:
As you can see, writing naked put options is a more conservative strategy and can be less risky than simply buying and owning stocks. As such it deserves to be considered an attractive investment alternative.
Myth #6: 90% of options expire worthless
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.
Myth #7: Only options sellers make money
The truth is that both option buyers and sellers can profit from option trading. If only sellers made money, there would be no buyers. With no buyers there would be no market. While options selling does have an edge in many cases, it also exposes you to negative gamma.
As Mark Wolfinger wrote: “Premium buying is the less-traveled road, but it can be profitable for the well-prepared, disciplined trader. It doesn’t mean it is better or worse than premium selling. It just means that there is more than one road to Rome.”
Myth #8: You Should Only Trade Options in a Tax-Deferred Account
According to George Ruhana, many investors are using options in their taxable accounts to help them make big returns precisely for their retirement planning.
“You’ve got this huge baby-boomer generation that’s got a lot of net worth to invest and they also have some time on their hands, if they’re retired, to do so. So people are really involved in [options trading] and they spend a lot of time on it. Trust me, when I talk to customers, they are laser focused on returns and how they’re trading and new ways to do things.”
Myth #9: Options are risky because they use leverage
The truth is that options can be used in many ways: Income, using non-directional strategies like irons condors and calendars, hedging, protection, speculation etc. Not all of them use leverage.
Myth #10: Options are only for short term trading
The truth is that many stocks have expiring options in 2-3 years. Those are called LEAPS (Long-Term Equity AnticiPation Securities)
There is more than one way to trade options. The key to success in options trading is using mix of diversified options trading strategies, like straddles, calendars, iron condors etc. In my opinion, you can rarely succeed in options trading by buying some cheap out of the money options and “hoping” for a big move.
Kim Klaiman is a full time Options Trader and founder of steadyoptions.com – options education and trade ideas, earnings trades and non-directional options strategies.