Five Notable Options Myths

1. All Options are Extremely Risky

Even though options are becoming more and more mainstream, there is still a large faction of the investing crowd that believes all options are extremely risky. In fact, there are many options strategies that are less risky than the underlying stocks they derive their price from. Out-of-the-money (OTM) options may be the culprit of this misconception as they tend to be cheap and lure many new, inexperienced investors with their cost. We all know that many things in life are cheap for a reason, and while there may be a time and place to invest in OTM options, you must always use caution.

Also, be sure you fully understand what your risk is at the onset of a trade. Buying options will give you a limited risk, typically at a cost that is cheaper than buying 100 shares of the stock outright. The other mistake options traders can make is to invest as much in options contracts as they would in 100 shares of stock. While this can increase leverage, it may also increase risk. There are actually options strategies that can greatly reduce risk and volatility and while some may limit profit, they can still provide returns that many investors would consider exceptional.

2. An Option’s Behavior is Mysterious and Magical

This is another complete misconception. Again, this myth stems from inexperienced traders who don’t understand how options are priced or realize how and why options prices change. Understanding all of “The Greeks” and how they measure an option’s sensitivity to specific variables is critical to grasping the behavior of options.

Remember that options:

Are legitimate financial products
Are not mysterious or magical
Perform “as advertised”
Require work to be properly understood

3. Market Makers are Out to Get Me (A/K/A: “They” Know What I’m Doing!)

We all like to blame others sometimes for mistakes that we make. Unfortunately, “market makers” get a bad rap, mainly because educators and commentators have painted that picture to the public or investors have come to that conclusion because they know the market maker may ultimately be on the other side of their losing trade. Market makers do exactly what their name implies, they “make” markets. This essentially means they provide liquidity and prices at which they are willing to buy and to sell an option, stock, index or ETF. As a former market maker myself, I can speak from experience that we were NOT in the business of upsetting investors. You see, market makers are providers of liquidity and the more volume they trade, the more potential they have to make money, so it would behoove them to encourage more trading.

That is not to say that if you do something stupid, you won’t be taken advantage of; there is an almost-certain guarantee that you will! We are all trying to make money, after all. Options market makers, unlike most retail traders, do NOT tend to have a directional bias when it comes to their methods. When a market maker is “forced” to buy a call, they will usually immediately do something to offset that delta risk, such as selling shares of stock or buying a put. I mentioned the word “forced” because remember, market makers are making a two-sided market (bid and ask). You are the one who is choosing what to do and the market maker is just deciding what price he is willing to buy or sell. In essence, market makers are placed into the trade by the opposing parties (most of the time), meaning you are more in control and have just as much, if not more, flexibility and freedom than the market makers do. Remember, no one forces you to execute any trade.

4. Buyers of Options are at a Disadvantage

This is yet another one of those myths that simply requires some basic knowledge. There is a time and a place for just about every options strategy. For novice, directionally-minded traders, buying a put or call may be the only strategy they can wrap their head around. For some, these are the only strategies they may ever employ (this is okay, by the way). If you understand “The Greeks,” namely theta, which measures time decay, you are already a step ahead in squashing this myth.

Buyers of options, both in-the-money and out-of-the-money, are able to gain leverage, reduce risk, and take advantage of movements in a stock with the potential of an increased percentage return, because of the option’s lower initial cost. That is not to say that buying options (along with selling them) is not without risk. Depending on your anticipated outlook on a particular stock, you may choose to buy or short an option or maybe even create a spread. Every strategy has advantages and disadvantages just as any stock investment does. It is up to you to educate yourself on what they are!

5. The Only Way to Make Big Money in the Options Markets is to Buy Loads of Out-of-the-Money Options

I was searching the net for popular myths for today’s article. One of the “get rich quick” strategies I found (actually a couple of them) involved purchasing a large amount of OTM options, because of the enormous leverage and relatively low cost of the trade. The trader went on to say that if the stock makes a big move, these OTM option buyers would score big benefits because the very cheap options would become very expensive. Traders who bought a large number of these options would then score a sizable profit.

I have a problem with just about every part of this statement. First off, as I mentioned earlier, some options are relatively cheap for a reason. The delta of an option not only tells us the change in the option’s price for every $1 move in the stock; it also tells us the percentage chance that option will have ANY value by expiration. Delta and price are directly correlated in the options world; the lower the delta, the cheaper the option.

Think about going to a horse track and finding a horse with 25:1 odds, (not to compare options trading to bookmaking or gambling, but the probability aspects are similar). This horse has obviously been given these poor (high-pay) odds for a reason. …

In the case of the horserace, you can bet what you want. Hypothetically speaking, you can place $5.00 on the 25:1 horse and $5.00 on the 1:1 horse, but here you know exactly what you can potentially win or lose depending on which horse you play. In options trading, each option has its own price, based on the probability of that option having value now and by expiration.

When you think about it, in trading and investing, we don’t really know exactly what our payoff will be because we don’t know where the stock will end up. Option pricing models can help us create a realistic probability thesis, and while they are not perfect, they can work to an extent. These models help price options based on those statistics and probabilities and in turn give us the delta of each option based on strike price, stock price volatility, and expiration date.

So after all that, would you bet all of your paycheck on the 25:1 horse, because you knew that there was a potential huge payoff? Hopefully you answered NO! That would be poor money management. Well, if you convert the winning odds of this horse, it basically equates to a 4% chance of success (based on odds), which is probably not something you want to “risk it all” on.

Unfortunately, options with a .04 delta or even a .10 delta have not only a low statistical probability of being worth anything at expiration, but they also will have a very low correlation to what the stock might do. This correlation (or lack thereof) can potentially cause frustration if the stock is moving and your option is not. So before you go and buy 200 contracts of a 40-cent option with a .04 delta, make sure you know what you are doing and remember the 25:1 horse analogy.

Photo Credit: spiraltri3e

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