Today I'm going to expose 10 common myths about options trading.
Myth #1: It's easy to make money with options.
I see too many "gurus" promise to make you money with no effort, charging thousands of dollars in the process. They present some of the highest risk strategies (like trading weekly options) as "low or no risk".
The truth is that 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. To become an engineer you have to study 4 years, and probably another 4 years (at least) to become a good one. Why people expect it to be different in trading?
Myth #2: Trading Options is only for Professionals.
Options were always a tool available to investors, but they were not as widely adopted because there was no supporting technology to help the industry. Then came the first online trading platform which brought the trading technology the pros were using to the general public. Since then, technology has improved exponentially and retail trading has started to be adopted by the masses.
What was true maybe 10-15 years, is not true today, due to technology changes, reduced broker commissions etc.
Myth #3: The only 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: on the 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: Options are for speculation only.
The truth is that options can be used in many ways. They can be used for speculation, but also for hedging, protection, insurance policy, income etc. For example:
- An investor who is long a stock but is concerned about short term volatility, can buy protective puts to hedge his investment.
- An investor who believes the market will be trading in a range, can trade range of income producing stratgies, like iron condors, calendars etc.
- An investor who wants to buy a stock at discount can use a naked put strategy.
Myth #5: 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.
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.
Myth #6: 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 in his article The Road Not Taken: "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 #7: You should aim for at least 100% gain in each trade.
Here are some questions you should ask:
- In order to make the 100%, how much do you risk?
- How much of your capital do you allocate for those positions?
- How much time do you give the trade to develop?
It might be better (and in some cases also less risky) to aim booking many 10-15% winners in short period of time (few days) than one 100% winner that takes 6 months to develop.
Myth #8: 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 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.
Writing naked put options is a significantly more conservative strategy and definitely less risky than simply buying and owning stocks. As such it deserves to be considered as an attractive investment alternative by millions of investors.
Myth #9: Trade only with at least a 2:1 reward to risk ratio.
The truth is that risk/reward is directly related to probability of success. Typically, good risk/reward = low probability of success and bad risk/reward = high probability of success.
For example, when you sell a $10 wide credit spread for $1, you risk $9 to make $1, but such trade would usually have about 90% probability of success.
So next time someone will ask you: "Would you risk $9 to make $1?" - consider the context. Yes, it is a terrible risk/reward, but considering high probability of success, this is not such a bad trade. It will likely be a winner most of the time - the big question is what you do in those cases it goes against you?
At the same time, the answer to the question "Would you risk $1 to make $9?" is also not so obvious. It is an excellent risk/reward, but the probability to actually realize this reward is very low. In trading, there is always a trade-off. You will have to choose between a good risk-reward and a high probability of success. You cannot have both.
Myth #10: 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."
- There is more than one way to trade options.
- Position sizing is one of the most important elements of trading, especially options trading.
- Few small winners achieved with low risk might be better that one big winner achieved with higher risk.
- Selling naked options might be actually safer than trading a stock.
- What is really important is not an occasional 500% winner, but an overall trading plan.
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.