Earlier this week I talked to Ian King about options trading.
If you missed “3 Biggest Myths in Options Trading — Debunked,” click below to watch our video:
As we said, options are a powerful investment tool. In fact, almost every investor should consider using options. Yet, many don’t.
When I ask why, many say it’s because they’ve heard that most options lose money.
Specifically, I often hear things like: “80% of options traders lose money.” Sometimes, the number is 90%, or more than 90%. It’s always a remarkably high percentage.
That’s a myth. Well, it’s true that many investors have heard that. But the statement isn’t true.
Options Have Winners and Losers
Options are different than stocks in many ways. (I won’t go into all the details of options here. But if you’d like to learn more, you can do so by watching my new presentation.)
One big difference is that winners offset losers in the options markets. Every investor in a single stock could, in theory, enjoy a gain or a loss.
In the stock market, companies sell shares to investors. Then, those shares are traded over and over. There are a limited number of shares, and each one represents an ownership interest in the company.
If a company is suddenly taken over, possibly every investor could profit from the stock. If a company enters bankruptcy, every investor will experience a loss on the stock.
Options markets don’t work that way. For an investor to buy an options contract, another investor needs to sell them that contract. Exchanges make this process easy.
You’ll never know who sold you an option, but it’s usually a firm that specializes in selling them.
With a lot of math and hundreds of millions of dollars in capital, these firms make a few cents on every trade. To generate that small profit, they create a market for individual investors.
Because the market creates a contract for each buyer, that means there will be a winner and a loser in each trade.
Even though winners and losers must be equal, some individuals insist that more than 90% of options lose money. That’s just not possible. Half of all traders will win, and half will lose.
There’s a Much Different Story for Options
Years ago, I tracked down the source of that misinformation. Turns out it’s fake news.
That study reviewed just a small number of options traded on the Chicago Mercantile Exchange over three years.
Researchers only evaluated options held on expiration day. This is a technical point, but it shows another difference between options and stocks.
Shares of stock live for as long as the company. All options expire.
Most options expire a few months from the current date. At the expiration date, the contract ceases to exist. Some will lose all their value by that day. Others will deliver large gains.
Before expiration, prices of options contracts move up and down with the price of the stock. During that time, you can sell the options contract. You might sell at a profit or a loss, just like you do with stocks.
In fact, most options contracts are sold before they expire. Many of them will be sold at a profit.
That famous study showing 90% of contracts expire worthless ignores all of those winning trades.
After reading the study, I pulled data from the exchange. What I found using the full set of numbers was that just 5.5% of all options expired worthless. The other 94.5% were sold before expiration.
That’s a much different story. It’s not as dramatic. All the data shows that options aren’t as risky as some investors fear.
Ian and I covered two more myths in our video, and we both reached the same conclusion: Options could be useful to many individual investors.
Michael Carr, CMT, CFTe
Editor, Peak Velocity Trader