10 Common Myths About Options

10 Common Myths About Options Disclosure For the sake of simplicity, the examples that follow do not take into consideration commissions and other t...
Author: Ezra Bridges
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10 Common Myths About Options

Disclosure For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and/or tax advisor before entering into any options strategy. Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in the Interactive Brokers website, and by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation. You can find this link in the chat window. You can also request a copy from IB customer service. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Supporting documentation for any claims will be supplied upon request. Market volatility, volume, and system availability may impact account access and trade execution. Copyright © 2011 Chicago Board Options Exchange, Incorporated. All rights reserved. CBOE is not affiliated with Interactive Brokers.

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Introduction • Listed options were introduced in the US by the CBOE in 1973 • Since the exchange was established, there have been myths regarding the option market • For 38 years, the CBOE has been trying to clear up these misunderstandings

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Number 1 Myth – Options are only for speculators.

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Number 1 Reality – Many professionals use options for portfolio protection. Options may be used as insurance policies. Options make investors think differently.

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Number 1 Example – Long 100 Shares of XYZ @ 41.50 Concerned about XYZ over next 30 days.

Buy 1 XYZ 30 Day 40.00 Put @ 1.00

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Number 1 Example Outcome – XYZ @ 35.00 at expiration. Loss of 6.50 on XYZ Shares Gain of 4.00 on 40.00 Put Net loss = 2.50 instead of 6.50

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Number 2 Myth –

Options are risky because they use leverage.

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Number 2 Reality – Options may be used in non risky ways. The key is capital management.

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Number 2 Example – QRS @ 38.50 Bullish on QRS for long term. Worried about QRS over near term. Don’t want to ‘miss’ stock. Buy 1 QRS 15 Day 40 Call @ 0.75

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Number 2 Example Outcome – 15 Days Later QRS @ 30.00 (down 8.50) Loss on 40.00 Call = 0.75 0.75 loss buying call versus 8.50 loss if shares had been purchased

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Number 3 Myth –

Options are only for short term trading.

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Number 3 Reality – Options may be used with a long time horizon. Many stocks have options with well over a year until expiration.

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Number 3 Example – May 10, 2011 – U.S. Steel Option Expiration Dates – May 20, 2011 June 17, 2011 July 15, 2011 October 21, 2011 January 20, 2012 January 18, 2013

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Number 4 Myth – 90% of options expire with no value.

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Number 4 Reality – The majority of option contracts are closed out before expiration.

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Number 4 Example* – Less than 10% of options assigned. About 20% of options expire with no value. About 70% of options positions are closed out before expiration.

*Options Clearing Corporation – 2010 Statistics CHICAGO BOARD OPTIONS EXCHANGE

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Number 5 Myth – Only sellers of options make money.

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Number 5 Reality – As noted in Number 4 more contracts are closed out before expiration. The truth is option buyers and sellers can profit from option trading.

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Number 5 Logical Explanation – If only sellers made money, there would be no buyers. With no buyers there would be no market.

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Number 6 Myth –

The market makers can not be beat.

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Number 6 Reality – Market makers trade as arbitrageurs. Their primary function is to provide liquidity to the marketplace.

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Number 6 Example – Market Maker Posts Following Quote – XYZ Apr 40.00 Call – 0.90 x 1.00 Customer pays 1.00 for option. Market Maker sells at 1.00. Market Maker hedges position for small gain.

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Number 6 Example – April Expiration - XYZ @ 45.00 Customer makes 4.00 on trade. Market Maker unwinds hedge for small profit.

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Number 7 Myth – Covered calls force you to sell winners and hold losers.

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Number 7 Reality – Stock may be called away if price is higher than strike. If called away shares may be repurchased. Short call option may be covered to avoid assignment.

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Number 7 Example – Long XYZ @ 43.50 Sell 1 XYZ 30 Day Call @ 1.50 25 Days Later XYZ @ 45.50 Buy Back 1 XYZ 30 Day Call @ 1.00 Still long stock – small profit of short call trade

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Number 8 Myth – Trading options is a zero-sum game.

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Number 8 Reality – Options may be used as insurance policies. They are more like risk management tools than trading vehicles.

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Number 8 Example – Long 100 XYZ @ 43.00 Willing seller of XYZ @ 45.00 Sell 1 XYZ Jun 45.00 Call @ 1.00

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Number 8 Example – June Expiration – XYZ @ 50.00 Stock called away at 45.00 (2.00 gain) Income from selling call 1.00 (1.00 gain) 3.00 profit on trade

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Number 9 Myth –

Selling puts is risky.

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Number 9 Reality – Put selling has been shown to be an excellent method of owning stock. Through selling puts an investor takes on the obligation to buy shares.

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Number 9 Example – XYZ @ 38.50 Willing owner of XYZ @ 35.00 Sell 1 XYZ Apr 35.00 Put @ 1.00

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Number 9 Example Outcome – April Expiration – XYZ @ 34.00 Assigned on short put position Long 100 shares of XYZ.

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Number 10 Myth – Option positions must be constantly monitored.

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Number 10 Reality – Any investment should be regularly checked. Option positions should be monitored as regularly as other investments.

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Conclusion

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As long as option trading has been around there have been common misperceptions Options are a tool that may be used to control risk and potentially enhance returns Now you can help us in clearing up some of these myths

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