Options Fact or Fiction
I‘ve been around the options markets for a long time. At least 15 years as a professional and several more as a public trader before that. I am constantly amazed by some of the "facts" I hear about options that are told to me as if they were written in stone. When I try to probe a little deeper to find the source, I get some nebulous answer like "I know it's true, but I don't where I heard it." Well, today I'm going to clear up some of those issues. To make this more fun, I'll present it as a Fact or Fiction test. For each of the 11 statements, circle either Fact or Fiction. (To protect your monitor, make sure to print this out before doing any circling.)
1) Fact or Fiction: Options are too speculative for the general public to trade and make money.
2) Fact or Fiction: Seventy-five to eighty percent of options traders lose money.
3) Fact or Fiction: Since 90% of options expire worthless, the best way to make money trading options is to do what the smart money (market makers) do, sell options.
4) Fact or Fiction: Options trading is a zero sum game, when one options trader makes money, another has to lose money.
5) Fact or Fiction: Being assigned on your short options position is bad.
6) Fact or Fiction: Claims of having an outrageously high (90-95%) win rate can possibly be true.
7) Fact or Fiction: If a stock is very volatile, then you should buy options since you can make money if the stock goes up or down.
8) Fact or Fiction: You're better off only buying low priced options to limit your risk.
9) Fact or Fiction: You should only buy Call options when you predict a stock is going up and only buy Put options when you predict the stock is going down.
10) Fact or Fiction: When you buy an option, even if the stock makes a big move in the "right" direction, there's no risk that the seller won't have enough money to pay you.
11) Fact or Fiction: Trading options is great, since you can put on a spread position and then go on vacation and not think about the position until you get back.
Now that wasn't so hard, was it? Let's see how you did.
1) Fiction: Options are a very versatile product. While they can be very speculative, they can also be used to hedge an existing portfolio, to provide a steady income, to diversify and spread risk, and there are also ways to use them to profit in any type of market. Also, even when options are used in a speculative way, the amount of risk can be predetermined and limited.
2) Fact: The sad truth is that most options traders do lose money. The key then is to learn more, which you're doing here at Online Trading Academy, and to work smarter and harder than the competition. In other words, there's a lot of competition in the options market and therefore, it's not easy to make consistent profits with minimal risk, but it is possible, and you can do it.
3) Fiction: A 2005 study by the Options Clearing Corporation showed that 48% of option contracts are closed prior to expiration, 17% are exercised, and 35% of options expire worthless. The argument that market makers generally are short options is true. However, think about what a market maker does. He trades with the public. Since most of the public is more comfortable buying options, the market maker naturally becomes short. You can be sure that if a market makers' inventory becomes too short, he will increase his bids to induce the public to sell options back to him. Being too short means not being able to sleep at night. Been there, done that.
4) Fact: When trading options, no money is created. So if you add up all the gains of winning options traders, it will equal all the losses of losing options traders. However, when you include stock trades and hedges in the calculation of the gain/loss, it is possible for total gains to be greater than total losses, or vice versa.
5) Fiction: Generally, you will only be assigned if your short options are deep in the money and already trading like stock. Granted if you're not expecting the assignment, there might be a cash flow issue, but that can normally be resolved upon hearing of the assignment on the next business day. Also, there are some strategies, like selling puts for example, where the objective is to be assigned.
6) Fact: Actually, with options it's very easy to put together trades that have a high win rate. But be aware, if a trade has a win rate of 95%, there may be a bomb waiting to go off in the remaining 5%, yielding an overall negative expectation for the trade. An example of this type of trade would be to sell short term deep out of the money puts on an index. You'll win most of the time, but when you lose, it can hurt big time.
7) Fiction: If only it was that easy! In a sense, options are priced by supply and demand and in accordance with the markets prediction of future volatility. In other words, if the market predicts that a stock is becoming more volatile, the options will be priced to reflect that prediction. There is no free money in the options markets.
8) Fiction: Low priced out of the money options are the options traders' equivalent of lottery tickets; high return, low probability. Serious traders don't consider that a business.
9) Fiction: That's certainly how a stock trader would think, but not necessarily an options trader. Options traders think more in terms of spreads. So, I wouldn't mind buying a Call option on a stock I think is going down, as long as I sell another Call, thinking it will go down a greater amount.
10) Fact: That's what exchanges are all about. The Options Clearing Corporation is considered to be the contra side of every trade and insures that every trade obligation will be met. Is it possible that something horrific could happen and the OCC couldn't meet its obligations? Highly unlikely, due to margin requirements and other safeguards, but theoretically possible. However, if that were the case, the financial state of the economy would be in such upheaval, that we would all have a lot more to worry about than our options trades.
11) Fiction: Despite what you might see on the late night cable channels, all positions must be monitored to some degree. The unexpected happens a lot more commonly than anticipated, and by keeping an eye on your positions, you'll be able to take defensive actions and minimize losses in those cases.
Okay, we're done. So how did you do? Based on the number of questions answered correctly, here's my totally unscientific analysis of your results:
11 a perfect score, I'm impressed, you should be writing the articles!
9-10 you're probably making money with your options trading
6-8 continue to read my articles, you're getting there
3-5 continue to read my articles, and the archives, and some options books, and….
0-2 Did you know that the Brooklyn Bridge is for sale?
I'm sure you're aware, but remember the markets are closed tomorrow, so no trading. Wishing everyone a happy 4th of July holiday weekend!!!
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!