A

merican humorist Artemus Ward provided powerful insights on options trading

when he said, “It ain't so much the things we don't know that get us in trouble. It's
the things we know that just ain't so.”

He’s right. It’s the myths and misperceptions that can cause the biggest problems.
Acting on misguided information gives you a false sense of security. You believe you’re
doing the right thing, when the opposite is true. But the more the myth is perpetuated,
the stronger the beliefs become – and the more dangerous it is.

Everyone knows that lightning doesn’t strike the same place twice, alligators can’t climb
trees, and rattlesnakes always warn before striking – myths that can get you killed in
Florida. While every industry has its set of dangerous myths, there’s probably no
industry where it’s more prevalent than with options. If you’re trading options, you need
understand the things we know that just ain’t so. They won’t save your life, but they will
save you a lot of money.
 Myth #1: Option Sellers have the Advantage
When trading options, you have two choices: You can be the buyer, or you can be the
seller. Option buyers pay money to have rights, while sellers receive the cash to accept
obligations.
But ask most options traders, and they’ll say it’s better to be the seller, but not because
they’re receiving cash. Instead, their reason is more technical: They believe 90% of
options expire worthless. Who wants to buy anything that ends up with no value?
If most of options expire worthless, it certainly seems you’re better off by selling. As one
trader told me, you don’t need to know anything about options to figure that one out.
Actually, you do need to not know anything about options to believe it. The 90% myth is
one of the most prevalent – and dangerous – in all of options trading. It’s a widespread
myth that’s handed down from trader to trader. If you ask them to show you the proof,
they’ll just say, “It’s just a widely known fact about options.”
Well, Bigfoot and the Loch Ness Monster are well known, but it doesn’t make them
facts. However, without any backing other than T-shirt salesman saying they exist, it
just makes them myths, and that’s exactly what the 90%-of-options-expire-worthless
rule is. It’s an overly cited statistic that makes traders believe that option sellers have a
built-in edge, much like a casino, and that selling options produces long-term gains.
The problem is that it steers traders into the sell side for no other reason than the
misperception of a big statistical edge. Unfortunately, these traders find out the hard
way that the edge doesn’t exist.
If you check the annual statistics from the Options Clearing Corporation (OCC), you’ll
see the following percentages usually occur:
60% of all options are closed in the open market
30% expire worthless
10% are exercised
For any given year, there’s about a five-percentage point swing to either side of these
numbers, so you may see somewhere between 25% and 35% expire worthless. But never
in the history of options since 1973 have 90% of options expired worthless. Not once.
There’s a good reason, as it would be difficult to push the number of worthless options
above 50%. By design, the exchanges always create a matching call and put for any given
strike and expiration, which are called corresponding options. For example, if there’s a
June $50 call option, there must be a June $50 put, which would be the corresponding
option.
Mathematically, any option that’s in the money must have a corresponding option that’s
out of the money.
It doesn’t matter where the underlying stock price is, as the answer is always the same:
50% of the strikes are in the money and 50% are out of the money. For example, let’s say
we’re right at expiration, and 60% of the June calls have intrinsic value, then so do 40%
of the June puts, but that only represents 50% of all June calls and puts. In other words,
if there are 10 strike prices for June, there are 10 calls and 10 puts, or 20 different option
strikes. If six calls are in the money and four puts are in the money, there are 10/20
option strikes with intrinsic value, or 50%.
However, not all strike prices necessarily have open contracts (open interest), so the
number of contracts that expire worthless won’t always be exactly 50%.
If you have 1,000 contracts as open interest for the June options, about 600 will be
closed in the open market. About 100 will be exercised. That leaves 300 to expire
worthless. Now, in this example, it is true that of the open contracts that were held to
expiration, 300/400, or 75% expired worthless. But that’s a far cry from all option
contracts, which would be 300/1,000, or 30%.
If you have a good mix of open contracts among the calls and puts for any expiration, it
would be nearly impossible to push the number of contracts that expire worthless above
35% or so – exactly what the OCC’s statistics show year after year.
Still, traders want to believe that 90% expire worthless and continue to be the seller
based on nothing but a myth. Just for fun, let’s give them the benefit of the doubt and
assume that 90% of all options expire worthless. Would it still be advantageous to be the
seller? It all depends on price.
Price is the Equalizer
The price of any asset is always adjusted to account for risk. For example, let’s say you’re
looking at a used car selling for $10,000 through a private seller. However, you find an
identical one on a dealer’s lot for the same price. Which do you choose?
You should take the one from the dealer, as it has a reputation to uphold, and certainly
doesn’t want negative publicity if there are problems. The car has also probably been
overhauled by technicians who will replace any worn parts. In other words, there’s less
risk in buying the car from the dealer, so it has more value to you. Because both cars cost
the same, it’s an easy decision. What would the individual seller have to do to entice you
to buy his car instead?
Lower the price.
As the selling price is reduced, it becomes more attractive. You may still say no to a
$9,500 offer, but would probably say yes to $8,000. In other words, at some lower
price, the risk of purchasing from the private seller will be worth bearing. At that price,
both cars are considered equal. Why? Because of price. The markets changed the price
to make both cars equally attractive in terms of risk.
Financial markets are no different. If it was true that 90% of all options expired
worthless, the price of options must fall to a point to reflect that risk. At that new price,
you can no longer say it’s better to be the buyer or the seller.
Here’s a game I offer to finance students to demonstrate the point:
Place the numbers 1 through 10 into a hat. Draw a number and drop it back in the hat. If
you draw the numbers 1 through 9, I’ll pay you one dollar. But when you draw the
number 10, you’ll pay me $10.
If you play this game hundreds of times, you’ll quickly find you’re on the losing side –
even though you’ll win 90% of the time. Strange, huh?
It’s easy to show by considering the odds of winning. You have nine ways to win for
every one way to lose, which makes the odds 9:1 in your favor. To make the game fair,
you should pay me nine times the amount you can win, or $9. In financial terms, $9 is
the fair value of the game, and if we played for a very long time, we’d both break even in
the long run. Neither side has an advantage, which is why it’s called the fair price, or the
fair value. Yes, you’ll nine times as often (90% vs. 10%), but that advantage has been
equalized by price, which was also increased by a factor of nine. The price was adjusted
to compensate me for the lopsided risk, so your 90% winning edge is eliminated. The
chart below shows a computerized version played 1,000 times:

Figure 1

Game Played at Fair Value ($9)

$80

$60

$40

$20

$0
0 100 200 300 400 500 600 700 800 900 1000
-$20

-$40

-$60

Notice that even though the above demonstration was played at fair value (paying $9
when you lose), the results can vary wildly. In fact, you can pick any two numbers, say
+$50 and -$50, and if you played forever, the blue line would pass through those
numbers an infinite number of times. In other words, there’d be times when you were
up $50 and down $50 – even though the game is priced fairly. But if you play long
enough, you’ll eventually come back to zero, which means you just broke even.
However, because the rules said you must pay $10 when you lose, there’s an edge
against you, just like a casino. You’re paying more than fair value. Play this game long
enough, and you’ll find money is flowing from your wallet to mine, as shown in the chart
below:
Figure 2

Game Played Above Fair Value ($10)

$50

$0
0 100 200 300 400 500 600 700 800 900 1000
-$50

-$100

-$150

-$200

-$250

Think about the above chart. If you saw your profit and losses looking like this, what
would you eventually figure out?
You’d realize you’re on the losing side and adjust the amount you’re willing to pay. You
may offer $9.50, which I’ll gladly accept, and you’ll still see money flowing toward me,
just at a slower rate. Once again, you’d eventually realize to lower the price even more.
What if the price got too low? What if you offered $8 and I accepted? Now we’d see the
reverse. Money would flow from me to you, and your profit and loss chart would be
rising. But then, I’d eventually learn that $8 is not enough money to compensate me for
the risk. This back and forth motion of changing prices would continue until we reached
$9. If I want to raise the price, you’ll say no; if you want to lower the price, I’ll say no.
We’d reach a point of equilibrium, and both of us will eventually realize that $9 is a good
price to pay when you lose.
Traders will respond no differently with options. Traders who don’t learn wash out. So
even if it was true that 90% of all options expired worthless, it doesn’t mean you have an
edge! Traders would realize that and adjust the price to eliminate that edge.
Flawed Market Studies
I’m aware of some recent market studies that suggest the favorable side of the trade has
been to the option seller – and even to significant figures of 70% of the time or more.
However, once again, they’re missing the point of price. They’re just looking at two
categories of “win or lose” and not considering the dollars. If we used the above
computerized games, studies would also show that at a price of $9 you’d win 90% of the
time. That’s completely true. But as Figure 1 showed, that statistic doesn’t account for
the dollars. The market price ensured you’d just break even in the long run. After
commissions, you’d be a net loser.
Of course, there are times when market conditions a ripe for option sellers. During
volatile times, or in strong bull markets, few people want to sell since their maximum
gain is limited, but their maximum loss is unlimited. To entice sellers, option buyers bid
up the option’s price above fair value.
The problem is, in the options market, we don’t really know for sure where fair value is
since that depends on future volatility. We know at expiration, but we don’t know today.
In the eyes of the market, however, the current option’s price reflects all perceived risks.
Option sellers may win a large percentage of the time during these conditions, but they
can get wiped out just as easily.
Be careful of anyone trying to sell you a program of option selling based solely on the
premise that 90% of options (or some other number) expire worthless and that you
therefore have an edge. If you fail to understand the role of price in the markets, it’s easy
to fall for the 90% myth because, unlike the Loch Ness Monster or Bigfoot, it’s hiding in
plain sight. The price you’re receiving from selling that option reflects the perceived risk.
On average, you’re not getting money for nothing. You’re getting a justified price for the
risk you’re accepting.
 Myth #2: Get In, Get Out
One of the unique characteristics of options is that they have an expiration date. Because
of this, they lose a little of their value each day. Most new traders are aware of this, but it
creates a dangerous misperception. If you talk to most trainers, they’ll tell you to get in,
and get out. In other words, grab quick profits when you can. It sounds like a good idea,
but so does throwing water on a grease fire – until you try it. What sounds like a good
idea, may be the worst thing to do. Getting in and out of trades quickly is one of them.
The reason so many traders want to grab quick profits is partly because people are
terribly risk averse. That means the pain from a given loss is far greater than the
satisfaction gained from the same-sized profit. If you made $10,000 on your first
options trade, it would be exhilarating, but probably not life changing. But if you lost
$10,000, you’d probably pack it up and go home in despair. That’s risk aversion.
When traders enter an options trade, risk aversion sets in, and they’re fearful of the
expiration date arriving and finding that their option is out of the money. The last thing
they want is to lose it all. The apparently logical thing to do is therefore get in and get
out at the first sign of profits. You’ll even find many brokerage firms teach clients to get
in and get out for the same reasons. The hidden agenda is that it generates commissions
– lots of them. When I worked on an active-trader options team, it was not uncommon
to see some people generating one million dollars per year in commissions. And yet,
their account values were usually far less than that. Getting in and out quickly sounds
good, but it will absolutely create long-term losses.
The first reason is that you’re intentionally limiting your profits, which goes directly
against the Wall Street adage to “Cut your losses short and let your profits run.” There’s
a reason Wall Street professionals teach that. You must allow for your profits to make up
for the many small losses (and some big ones) that are bound to occur. If, however,
you’re always getting out at the first sign of profits, you’re picking up nickels in front of
bulldozers. It’s a matter of time before you’ll be flattened.
Yes, I know, some traders say that’ll never happen to them since they watch their trades
closely. If you think that’s good advice, try it. Watching a computer screen doesn’t affect
stock prices. You can gaze into the screen all day long without blinking, but if the stock
halts trading and gaps 20 points lower, there’s nothing you can do. Unexpected large
losses are bound to occur, and anyone saying otherwise hasn’t been trading long
enough. The good news is that unexpectedly large gains are bound to occur – provided
you didn’t sell early.
A second reason is that if you’re focused on collecting profits, at what point do you place
the sell order? If you buy an option for $3 ($300 total) and can sell it for $3.20 ($320
total), do you take it? Why wait for a price of $3.30? If your goal is to capture a profit
when you can, you’ll always be selling early. If you earn 20 cents on 10 trades, that’s
$200. But if you pay $10 per trade, that’s $100 in commissions. The broker earned 50%
of what you made – with zero risk.
Here’s another thing to consider: Let’s say you turn the first $300 trade into $320.
Okay, great, but what will you do next? You’ll place it into a new trade unless your entire
goal for investing was to earn a one-time $20 profit. But what makes you think this new
trade will be any safer than the one you just exited? If you’re kayaking in rough waters,
stopping every few minutes and changing to a different colored kayak doesn’t make it
safer. That’s all you’re doing by getting out of trades and switching to a different ticker.
If the stock rises from $100 to $120 over a few months, it’s a $20 move no matter how
you cut it. Getting in an out dozens of times during that move doesn’t make investing
any safer or more profitable – except to the broker.
Traders who tout taking early profits usually quote Jesse Livermore who said, “Nobody
went broke taking a profit.” It’s absolutely a dangerous one to live by and for this very
reason. Teaching people to jump at the first sign of profits is a sure-fire way to take a few
large hits, but have few profits to compensate for them.
The thing I find interesting is that nobody would take this approach to running a
business, but these same people somehow think it makes sense for investing. Treat it
like a business. If you start three businesses that fail, but then find a new one that takes
off, do you sell at the first sign of a profit?
The better way to approach options trading is to learn to hedge, roll, and morph
positions. For example, assume you buy a $50 call for $3. Later, the stock rises, and the
call is now trading for $5. Rather than grab the profit, you can roll the position to a
higher strike of the same expiration month, say the $55 call.
By rolling, it means to sell your current $50 call and simultaneously buy the $55 call.
Mathematically, the $50 call must be worth more money since it’s giving you the right to
buy shares at a lower price ($50 rather than $55). That means the money you’re
receiving from selling the $50 call will more than cover the cost of the $55 call – and
leave some extra cash in your account. If the $55 call is trading for $1, you can execute
the trade (sell the $50 call and buy the $55 call) for a net credit of $4. You’ve put $4
back into your account, which has more than paid for the original $3 price: Now you
can’t lose. The worst that can happen is that you paid $3 and pocketed $4 – a 25% gain.
However, since you still own an option – the $55 call – you can capture more profits if
the stock continues to run. That’s where the real money is made.
Sure, there will be times where, in hindsight, you’d have been better off to just close the
option rather than rolling it to a higher strike. But you can’t let that throw your trading
plan. Make the commitment to stay in the position rather than making a quick exit.
Another reason to hang on to options longer than many people suggest is that they’re
already hedged. By purchasing an option, you immediately have limited risk. If you buy
the $50 call for $3 ($300 total), that’s the most you can lose. If you had, instead,
purchased 100 shares of stock for $5,000, there’s no way you could guarantee to limit
your losses to $300 – no matter how closely you watch it. This limiting downside is one
of the most powerful aspects of options, but when you make a quick exit, you’re failing
to take advantage of it.
In the Alpha Trader course, I show that a call option is really the same thing as 100
shares of stock plus an insurance policy with a put. Mathematically, that means the call
option is the same thing as owning shares of stock with an attached insurance policy.
You’ve paid for the insurance – let the stock run. Hang on and make lots of money.
Don’t sell yourself short and settle on a few breadcrumbs after commissions – even
though you can rack it up in the “win” column. Some of the best traders in the world
only win with 30% or less of their total trades. That’s because they’re masters at hanging
on and making lots of money. The art of options trading comes from learning how to
stay in the position – but manage the risk as prices change. It never comes about from
getting in and getting out.
There’s one exception: If you do happen to run into Bigfoot – get out!
 Myth #3: Cheap Options are Less Risky
Which option has more risk: A $100 call purchased for $1, or a $100 call purchased for
$10?
It’s a trick question, but most traders would immediately vote for the $1 option. Their
reason would be that you can only lose $1 rather than $10. However, the amount you
can lose has nothing to do with the risk.
Risk is defined as the probability of losing money – not the amount of money that could
be lost. If you place one million dollars into a Treasury bill, it has absolutely no default
risk. You’ll always get 100% of your money of your money back, plus a little interest.
However, if you buy a lottery ticket for one dollar, you’re nearly guaranteed to lose it.
Even though one million dollars is a far greater amount than one dollar, the risk of the
lottery ticket is much greater. There’s more certainty regarding losses.
Markets price all assets according to risk. If something is risky, or perceived to be risky,
traders bid the price lower to account for that risk. If there’s little to no risk, markets bid
the price higher since there’s no fear of losing money.
One of the best ways to demonstrate this is with a pricing game I created for finance
classes. It’s best to play in a live setting with a large group, but just assume you’re in a
room with hundreds of people.
We’re going to hold an auction to play three different games. If you want to play, you
must be the highest bidder. You won’t get your bid price back, but you will have the
opportunity to win $100 cash. How much would you pay to play each of the following
three games? Think about each for a moment and jot down your answers on a piece of
paper:

Pricing Game
Let’s start the auction with a chance to win $100 cash – guaranteed.
All you have to do is be the highest bidder. If you’re the highest
bidder, you can walk to the front of the room and grab the $100 cash
with no strings attached. How much is this opportunity worth to you?

For the second game, you must correctly call heads or tails at the flip of a
coin to win the $100 prize. How much do you bid to play the game now?
 For the third game, you must draw the ace of spades from a well-
shuffled deck of cards to win the $100. How much would you pay
to play now?
Now that you’ve written down some answers, let’s look at the
pattern. Even though I don’t know the answers you chose for each
game, I’m 100% certain you elected to pay the most for the guaranteed game, the next
highest amount for the coin game, and the least amount for the card game. Why?
It’s the relative risks involved in each game. The first game has no risk, so the highest
bidder always wins $100. Because of this, most people will bid this game up fairly close
to the $100 reward. It’s no different than walking up to a bank teller and asking for
change for $100. It’s a guaranteed transaction, so the price of $100 is $100. However,
for the auction, participants will leave a little room for profit, so you may find that the
highest bidder is $99.
For the coin toss, we know that you would win $100 half the time and lose half the time,
which is certainly not as good as winning all the time. In other words, you have less
confidence in the outcome – there’s risk. Because of this, you should be willing to spend
less for this game. Let’s say the highest bidder pays $40.
For the card game, you would win $100 only once out of every 52 tries, on average, so
you’re almost certain to lose your money. On a comparative basis among the three
games, this is the riskiest so you should be willing to spend the least to play it. Let’s say
we get one dollar from the highest bidder.
Now look at the results:
Game Highest Bid Resulting Reward
Guaranteed $99 $1
Coin $40 $60
Card $1 $99

Once we have some prices to work with, we can look at the three games in a different
way. If you were willing to pay $99 for the first game, that’s the same thing as saying you
were willing to invest $99 to make a $1 profit. The coin game, on the other hand,
represents a game where you could invest $40 for the chance to make a $60 profit while
the card game represents an opportunity to invest $1 in hopes of making a $99 profit.
Notice the relationship between the prices and the rewards: The higher the price, the
lower the reward. The guaranteed game carries the highest price of $99 yet comes with
the smallest reward of one dollar. The coin game has a lower price – and a bigger
potential reward. The card game has the lowest price – but the absolute highest reward.
The reason for this price and reward relationship should now be obvious to you. It is
solely due to the risk of each game. The bigger the risk, the less you are willing to pay,
and that allows for a bigger reward.
The deadly misperception among traders is the belief that the card game must be the
least risky since you can only lose one dollar. The logic is just the opposite: It’s high risk,
which is why the market bid down the price.
Option prices work the same way. If the underlying stock is $100, a one-month, $120
call has little chance of expiring in the money, so traders bid the price down, perhaps
only one dollar. The low price is a reflection of the high risk of loss. You can also see the
risk by looking at the expiration breakeven point. The stock price must be $120 strike +
$1 premium, or $121, at expiration just to break even. The stock must rise 21% in a
month just to get your money back. That’s a highly unlikely event, so it’s relatively high
risk.
On the other hand, if an option has a low chance of expiring out of the money, traders
bid the price higher since there’s a high probability the option will expire with at least
some intrinsic value. For example, if the underlying stock is $100, the $90 call may be
trading for $10.50. The expiration breakeven point is $90 strike + $10.50 premium, or
$100.50. The stock only needs to rise 50 cents, or 0.5% to break even. That’s far more
likely to happen when compared to the need for a 21% increase. It’s therefore a lower-
risk option.
Look at the Microsoft option quotes below. Notice the bid prices become lower as the
strike price is increased. That will always be true for any stock or expiration date. That’s
the traders’ responses to increased risk:

If you ask most traders, however, they’ll insist that the $75 call, for example, is less risky
than the $65 call since you can only lose $1.40 rather than $8.70. That’s a myth, and
believing otherwise will create unwanted surprises. To succeed with options trading, it’s
best to have a strategy and game plan that suits your needs. Once that’s defined, only
take just enough risk to meet your goals. There’s no sense in taking additional risk.

For options trading, however, risk comes in many forms. Most are hidden – until you
learn to uncover them. To make the best decisions, you must understand concepts like
volatility, delta, gamma, theta, and vega along with their effects against time and stock
price changes. These concepts cause the greatest myths options trading – the things we
know that just ain't so.

The Alpha Trader Certificate Course teaches the art and science of options trading.