Five myths about trading options
With increasing market volatility over the past few years, investors might feel as if they’ve lost control of their portfolios. Watching the market decline can be a frustrating and stressful experience, especially because many investors don’t recognize there are strategies to control the ride.
One of the ways to avoid paying too much for a stock – or to guard against a major loss – is to use a financial instrument called an option. It sounds complicated, but the premise behind options is easy to understand. Options are contracts that give the right to buy or sell securities, which can include stocks, exchange-traded funds (ETFs) and indices, for a predetermined price over a set timetable. Throughout this article, we will be using stocks as our primary example. Typically, options are sold in blocks of 100 shares or units.
Since options are only buying the right to buy or sell a stock, the purchase price for the option is often substantially lower than buying the stock outright. There is no obligation to exercise the option, which results in the investor taking ownership of the stock; giving them more flexibility in their approach to the market. Let’s review the most common option types:
Call options allow holders to buy a security at a predetermined price within a specified time frame. Let’s say if someone expects a company to perform well, but either doesn’t have the capital to invest or doesn’t want to commit too much to one investment right now. Rather than lock in their money by purchasing the shares themselves, they could buy a call option to lock in the price they’re willing to pay for shares in that company in the future.
For instance, if shares in Company XYZ are trading for $50, they might be able to buy a call option for 100 shares at $55 at some point in the next six months for $125 plus fees. (Generally speaking, options can be bought for $1.25 per contract or share.) If Company XYZ’s share price suddenly rises to $60 a share, the value of the option would be worth $500 (($60 a share – $55 a share) x 100 shares), less the initial $125 that was paid for the option.
Typically, the strike price – the price one can can buy shares or units for – stated within the option contract will be slightly higher than the current trading price. If the shares or units in the security rise above that price before the options expire (options in this position are considered to be “in the money”), then the option holder will profit on the option by being able to buy the shares or units below the market price. The higher the security climbs above the strike price, the more valuable the option becomes.
Put options are the opposite of call options. They allow investors to sell a stock they own at a set price within a set time frame. Generally, these options are used to hedge against a loss. If the value of a stock drops below the price specified in the option contract before it expires, then the put option will be “in the money,” and the holder will be able to sell their shares or units for more than market value. Put options effectively provide a floor for losses.
Let’s say someone owns shares in Company XYZ and they are trading at $55, but they’re worried the price could fall. They could buy a put option to sell 100 shares at $52 at some point in the next six months for $125 plus fees. If Company XYZ’s share price suddenly falls to $50 a share, that option would be worth $200 (($52 a share – $50 share) x 100 shares), less the initial $125 they paid for the option.
Options are often misunderstood
Several myths have emerged around options trading over the years that make them sound overly complex and risky, but many of the fears are overstated. Here are some common myths about options.
Myth: Options are complex and hard to understand.
Reality: Options sound more intimidating than they are. If someone has ever set up an alert to flag when an item goes on sale, then they’d understand the basics of how options work. For a fee, the option holder can earn a chance to buy a stock that may be “on sale” in the future. Adding this level of sophistication to a trading strategy can help investors avoid overpaying for a stock. There are plenty of resources available to investors, including practice accounts, that will give a risk-free way to get some hands-on experience with options. If investors have taken the time to understand things such as fees and asset allocation, then this is a worthwhile way to take their trading to the next level.
Myth: Options are high risk.
Reality: When someone buys a call option, they are speculating that the stock will rise above a specific price before a predetermined date. With this approach, they’re only buying the right to buy a stock, not the stock or unit itself, so the price – and therefore the risk – is much lower than when buying an investment outright. If each option has 100 shares or units, the cost would be $125 (given the $1.25 per option) plus the trading commission. By comparison, if shares or units in the underlying investment were trading at $25 a share, they’d need to risk $2,500 to capture almost the same upside potential offered by the $125 option, less the cost of the option itself. Using options can also help free up capital to invest in other opportunities.
Myth: Most options expire worthless.
Reality: Some accounts suggest that 90% of options are never exercised. While it’s true most estimates suggest only about 10% of options are exercised, that doesn’t mean the others result in a loss. Up to 60% of options will be closed before expiration, meaning holders can try to trade them to recoup some of their investment. That means only 30% of options are allowed to expire without being exercised. Moreover, an option doesn’t have to be exercised to realize its value. Options can be traded, which gives another opportunity to recoup some of the cost if there are worries that the options won’t be in the money.
Myth: Options are for short-term trading.
Reality: It’s always advantageous to have a choice; that’s what options give. Options can have long and short durations. There are options that don’t expire for months or, in some cases, years. These options can be quite valuable in certain circumstances. For instance, while puts are generally viewed as a bearish strategy, investors don’t need to have a pessimistic view of a stock to benefit from them. A bullish investor might put something called a “protective put” in place to guard against loss or uncertainty. A protective put effectively means that while they’re hoping to make their profit from the rising value of the stock, they would buy the option as insurance in case the stock unexpectedly drops in value. While the cost of the option, or the premium, reduces the profit on an investment if the price of the stock or unit rises, it creates a floor for those losses. A protective put can be bought any time, as long as the stock is owned.
Myth: Option sellers are the only winners.
Reality: If only the sellers made money from options, then sophisticated investors, such as pension plans and hedge funds, wouldn’t use them. In the U.S., options trading is a trillion-dollar market. Also, options don’t need to be exercised to make money. If options are in the money (meaning the market price for the stock is above the strike price), then the holder can decide to sell the options for a profit. On occasion, if the market anticipates the value of a stock will continue to rise, depending on when the options expire, the holder may be able to sell the options above the current market value.
Over time, options have gotten the unfortunate reputation to be risky and overly complicated, whereas the reality is that options can offer an effective way to manage risk. It’s important that options-based strategies don’t get overlooked because of myths like these, as they can broaden up the range of investment opportunities to help deliver desired investment outcomes for investors.