Options myths and misconceptions

14 May 2018 by National Bank
elephant on a branch

Jason Ayres, from the Montréal Exchange, dispels some myths with regard to options.

For those who are just beginning their options education journey, I am sure you have been presented with many opinions—from other investors and investment professionals alike—regarding the pros and cons that options bring to a portfolio.

Unfortunately, many myths and misconceptions have arisen due to a lack of understanding despite all the great educational material and guidance available today. Proactive investors who endeavour to learn the dynamics of the options market are still often discouraged by those who are misinformed.

In this article, I’ll be highlighting some of the most common myths and misconceptions with the intention in adding some clarity so that, as you move forward in your educational journey, you can do so with a clear and objective understanding.

Myth 1: Options add more risk

The truth is that, yes, there are risks associated with using options. This is true of all financial instruments.

The reality is that options can be used to meet all sorts of objectives and each strategy has its own risk/reward profile. Being the buyer or the writer of an option, using a spread combination, or holding the option position in combination with the underlying security, among other things, will all have a significant influence on the level of risk associated with using the options market. The investor must first fully understand the strategy and all its nuances before executing the trade. We control the risks through the decisions we make.

For an outline of the risk/reward profile of some of the most common strategies, you can access the Montreal Exchange’s Equity Options Reference Manual.

Myth 2: Puts are riskier than calls

The reality is that puts are priced the same way that calls are based on the potential for the underlying security to move higher or lower. As mentioned above, risk is at the discretion of the investor and will depend on the strategy selected. For example, a Naked Call Write (selling the call without holding the obligated shares) represents a greater risk exposure than a Long Put.

Myth 3: Options are a Zero-Sum Game and that means more risk

First, what is a “zero-sum game”? This is the theory that the gain of one participant is the same as the loss of another. For example, if the call buyer pays $1.00 and the call writer receives $1.00, when the call expires, the buyer will have lost $1.00 and the writer will have gained $1.00.

The reality is that while options are a zero-sum game, it does not mean that there is a defined winner or loser. Consider that when a Covered Call writer sells a call for income, he may be assigned to deliver the shares to the call buyer who wishes to own them. In this case, both the Covered Call writer and the call buyer will have successfully accomplished their objectives.

Myth 4: Most options expire worthless so buying options is a bad idea

The reality is that this is directly dependent upon the strike price selected for the strategy. Out-of-the-money options do have a greater probability of expiring worthless and are priced accordingly. At-the-money options have a 50/50 probability of having a value at expiration or expiring worthless.

According to the Chicago Board Options Exchange:

  • approximately 10% of options are exercised during the expiration cycle,
  • 55–60% of options are traded out before expiry to cut losses or lock in profits,
  • 30–35% expire worthless.

In 2017, 4.58M option contracts were exercised in Canada. This represents slightly more than 13% of total options volume. Once again, the outcome will depend on your strategy and contract selection as well as on how you manage the position.

Myth 5: Covered Call Writing underperforms

The profitability of the Covered Call strategy is a function of the market environment, stock selection, and risk management. Statistics show that strategic Covered Call Writing can not only increase returns but can also lower portfolio volatility and increase the Sharpe Ratio which reflects the amount of return generated for every unit of risk.

Note that in the graph below, Covered Call Writing on the XIU as reflected in the MCWX index not only resulted in enhanced returns, but also in a lower standard deviation and a higher Sharpe Ratio.

To conclude, these are just a few of the typical myths and misconceptions that you may be exposed to as you continue to educate yourself on the use of options.
While there are risks involved, a lot of them can be controlled and managed by:

  • Ensuring that you have taken the time to understand the trading characteristics of the option market thoroughly;
  • Clicking the trade button only when you are confident that you have selected the right strategy and contracts;
  • Knowing your risk exposure and having a plan to manage through the trade.

The Montréal Exchange invites you to enhance your options trading skills with the 11th edition of Options Education Day.

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