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Among all options, the most easily calculated payoffs are those for long options. But there remains a great misunderstanding, even among experienced option traders. This must be clarified before moving forward. The misunderstanding is often seen expressed online and in the literature: “75% of long options expire worthless.”

This if false. The fact is, 75% of all options held to expiration expire worthless. But between 55% and 60% of all options are closed or exercised early, leaving 40% to 45% of options held to expiration - -and some of these are closed profitably even on the last trading day. Although the actual outcomes vary, historically only about 20% to 25% of options held to expiration will expire worthless. The rest will be closed at a gain, breakeven, or a small loss. In order to be worthless, they must hold no value on the last trading day, and that is where the myth is derived.

The conclusion: long options are much lower-risk than many people believe, and even experienced options traders may fall into the misconceptions about risk levels for long options. So much of the risk varies depending on other facts, including time to expiration (and the rapidity of time decay) and moneyness. The closer to the money, the more responsive premium movement will be to underlying movement, so this presents a key variable. In other words, not all options are the same in terms of risk levels.

Long options are used for speculative trading and can benefit from an existing trend in the underlying, if the trend continues. Traders can also use long options as a highly leveraged form of swing trading. It makes sense. For a fraction of the cost of buying shares of stock, you can control 100 shares with a relatively inexpensive option. If you time the trade take advantage of exaggerated underlying price movement, a swing trading program based on options can be lucrative. Those price swings are most likely to be founds right after large earnings surprises,  when the stock price moves beyond a reasonable level, and of course, options follow.

An advantage to trade timing base don options is that both calls and puts can be used in the same way, depending on the expected direction of counter-movement after the exaggerated price occurs. But even if you use options purely to speculate, a recurring question arises about whether it is an ethical practice:


On one side of the debate, many have criticized speculation as unethical and harmful … speculators increase market volatility and cause markets to be inefficient … On the other side of the argument, many have stated quite the opposite – speculators improve market efficiency by usually buying when prices are below their fundamental value, and selling when prices are above … [Tokic, Damir (2014). Legitimate speculation versus excessive speculation, Journal of Asset Management, 15(6), 378-391]

Although speculation does occur among options traders, it is not as widely practiced as hedging, the use of options to reduce risk in equity positions. Where traders run into problems is responding to momentary market conditions against their well understood risk profile. For example, a conservative risk hedger may revert to a speculative trade because it appears the opportunity is there for the moment. But if the market moves against this position, the “conservative” hedger becomes a speculator and may lose money as rapidly as gains were expected. A strictly defined “conservative” trade is one where the option is specifically tied to the equity position for hedging purposes, and where speculation is rare or never practiced at all.

The conservative will recognize that speculation is high-risk whereas hedging is low-risk. The smart trader has to answer the risk-related question, “What is my risk profile? This appears to be basic and obvious, but actions often betray how traders behave. If you truly are conservative, your trades reflect it. If you are a speculator, the you cannot practice that and at the same time, be a conservative trader who relies only on hedging. A possible solution is to diversify risk profile. Use the larger part of your portfolio for hedging with options related to equity positions and set aside a relatively small portion of your portfolio for the occasional speculative trade.

Even speculators may justify the hedging strategy, especially if they have picked equity positions in lower-quality stocks. This occurs all too often because options traders are attracted to volatility and the potential for big gains, only to later realize their exposure is greater than they want. The practice of hedging among speculators:


… can be justified if the hedger feels that the stocks in the portfolio have been chosen well. In these circumstances, the hedger might be very uncertain about the performance of the market as a whole, but confident that the stocks in the portfolio will outperform the market … [Hull, John C. (2012). Options, futures and other derivatives, 8th ed. New York: Prentice Hall, p. 64]

This form of “speculative hedging” makes perfect sense for those traders willing to live with a higher risk profile. Upon realizing that the risk levels are excessively high even for them as speculators, a hedge can be a useful safety net. Ironically, the use of long options even in a more speculative environment often is more conservative than using options to swing trade. This is especially true if only long options are used. Many swing traders have figured out how to hedge their swing risks by combining long and short options and even swing trading with covered calls or short puts to maximize positions. These highly conservative options can apply a swing trading strategy while avoiding the common flaw in swing trading otherwise: making a series of small profits only to then suffer one large loss, wiping out all the previous gains.

Determining your appropriate risk level for the use of long options should be part of the definition of a risk profile. Once this is done, it is an easier next step to decide whether to dabble in speculation at times, and whether to use hedging to add a layer of protection, even to an otherwise speculative position.


Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

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