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Options Myths vs. Facts

Contrary to what many think, the vast majority of options do not expire worthless. The facts are as follows: approximately 10% of options are exercised, from 55% to 60% of option positions are closed prior to expiration, and about 30% to 35% of options expire worthless. Note that 90% of options go unexercised, which is very different than expiring worthless. It should also be noted that this says nothing about profitability. Option positions closed prior to expiration may be profitable or unprofitable. Options that expire worthless may not be unprofitable if they were part of a strategy that involved other securities such as covered call writing.

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It is a fact that purchasing options is a limited-risk strategy: The most the buyer of an option can lose is the amount paid for the premium plus commissions. Another way to look at this is that the buyer of an option has less capital at risk than the equivalent position in the underlying asset. What is more important to focus on than the inherent leverage in options is the probability of gain or loss. Low-priced options tend to be short-term and out-of-the-money. These are the options with the very highest probability of expiring worthless. The options toolbox software, available without cost at, allows investors to evaluate these outcomes and probabilities prior to trading.

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The financial condition of the buyer or sellers of option contracts is not a matter of concern for investors. The counterparty to every option transaction is the Options Clearing Corporation or OCC, which guarantees the performance of the terms of listed option contracts. Should a party default on an option trade the OCC would ultimately make good on those contracts. The OCC has been given an AAA credit rating--the highest rating given by Standard & Poor's Corporation.

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Although only approximately 10% of options are actually exercised, and the majority of those are exercised very close to the expiration date, a number of options are exercised prior to expiration. In fact, in-the-money equity call options will at times be exercised before expiration just prior to the stock going ex-dividend. The holder of an equity call option may exercise early to capture the dividend that would be foregone if the option were only exercised at expiration. For equity call options, the risk of early exercise is greater immediately prior to the underlying stock going ex-dividend. Equity put options are also occasionally exercised early. Early exercise of puts tends to occur when in-the-money puts are trading near parity (at their intrinsic value, no time premium left). Investors must remember that puts have a tendency to go to parity more readily than calls. So for put options, if the time premium has completely eroded, the risk of early assignment must definitely be taken into account.

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Numerous investors prefer to trade shorter-term options. But if someone has a different time frame in mind, the options market may still be able to meet his or her investment needs. In fact, for all optionable stocks, options with expiration dates of six to eight months are listed for trading. For a more limited group of stocks (the ones with the more active and liquid options), longer-dated options, known as LEAPS, are also listed for trading. LEAPS give investors the possibility of establishing option positions of anywhere from nine to a maximum of 32 months. So if your outlook is based on longer-term forecasts, LEAPS may provide you with the leverage and limited risk similar to short-term options.

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Buying options is not necessarily the best way to profit from a volatile stock. Investors must keep in mind that options will be priced according to the volatility of the underlying stock. Generally, a relatively stable, low-volatility stock will have relatively inexpensive options; a more volatile stock will have much more expensive options due to the greater uncertainty about future stock prices. The stocks historic volatility will be taken into account in the options' pricing. Investors buying options to take advantage of a volatile stock must remember that the options market has taken this fact into account also. The resulting option prices will usually include a premium for that historic volatility. If the underlying stock does not behave in the future with as much price volatility as expected, this "volatility premium" in the options prices will erode, sometimes dramatically.

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Very often when investors purchase options, they do so from a professional option trader (a market maker) who thereby becomes the seller of the option, and vice versa when an investors sell options. It stands to reason that if the buyer of the option (i.e. the investor) is to make money, the seller of this same option (i.e. the market maker) must lose a corresponding amount. It appears as though public investors are in competition with the pros, and would therefore make no sense to argue with experienced, savvy market makers. In fact, the public and market makers are not in competition with one another. The investor who purchases an option usually does so because he or she has an opinion about direction: Call buyers are bullish, put buyers are bearish. Investors purposefully establish positions with a directional bias. When market makers sell or purchase options, it is usually because a public customer wants to buy or sell an option; market makers may have no opinion about the probable direction of a stock. What do they do? In the best of all possible worlds, a market maker who sold an option at 2 would try to buy it back at 1-7/8, make a small profit and have no market exposure. In most real-world cases, a market maker who sells an option may not be able to buy it back quickly at a profit. What happens then, wait and hope the stock goes in the right direction? For most market makers a wait and hope strategy would be a recipe for disaster. Instead, they will hedge their positions, either by buying or selling a different option, or many times by buying or selling the underlying stock or security. It turns out that investors and market makers are not competing against one another: investors are trading a directional opinion, while market makers are hedging their positions and trying to lock in small profits due to small price fluctuations in a series of options and the underlying security.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available from your broker or The Options Clearing Corporation, 400 S. LaSalle Street, Chicago, IL 60605. CBOE and Chicago Board Options Exchange are registered trademarks of the Chicago Board Options Exchange, Incorporated. 2002 Chicago Board Options Exchange, Incorporated, All Rights Reserved.

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