Back to Basics Friday: The Biggest Options Myth Dispelled

One promoter who likes the idea of writing covered calls states that:

“Over 75% of all options held until expiration expire worthless… That’s why you should do what the pros do and sell options to other people. After all, if most of them will expire worthless, why not collect some money for them today while they still have value?”

Another advisor states that “Selling covered call options and cash-secured puts is a smarter strategy than buying options because 90% of options expire worthless.“

The truth is that neither of these beliefs is close to being accurate. The first person quoted is just plain wrong in his beliefs because he ignores the risk associated with selling options. To me, his statements suggest that selling naked options — as an alternative to selling covered options — is a wise strategy. However, it is fraught with risk.

The second person’s statement is also flawed, but it contains a nugget of truth. More traders believe that it is “smarter” to sell, rather than buy, options. However, attention must be paid to limiting risk.

I agree with the bottom line that writing covered calls is a sound strategy for most investors. NOTE: It is not as valuable for short-term traders.

The Numbers

According to historical OCC statistics for the year 2015 (for activity in customer and firm accounts), the breakdown is as follows:

  • Position closed by selling the option: 71.3% exercised: 7.0%
  • Held and allowed to expire worthless: 21.7%

This data from the OCC is accurate. So why do so many people believe that 90% of options expire worthlessly? Basically, it is a mistake in logical thinking.

Let’s look at a simple example: Note: open interest is measured only once each day. Assume that a specific option has an open interest (OI) of 100, and that 70 of those options are closed prior to expiration.

That leaves an OI of 30. If 7 are exercised and 23 expire worthless, then 77% of the open interest (as of the morning of expiration day) expires worthless. Those who do not understand this subtlety claim that so much of the open interest expires worthless.

The truth is that a high percentage of the open interest that remains until expiration day expires worthless. That is a very different number than the total open interest.

Covered Call Writing and Expiring Options

Most option novices love writing covered calls when the option expires worthless. The truth is that this is often a very satisfying result. Traders still own the stock, the option premium is in the bank, and it is time to write a new option and collect another premium.

However, that mindset is a bit shortsighted. Sure, when you buy stock at $49, write calls with a $50 strike price, and the options expire with the stock price at $49, (or a bit higher) — the strategy has worked about as well as can be expected and the trader is patting him/herself on the back.

However, there are two situations in which the trader who achieved this happy (options expire worthless) result probably made a serious mistake while waiting for the options to expire — a mistake that cost him/herself some cash.

Let’s look at these seldom-discussion situations.

  1. The stock price has plummeted. It may feel good to write an option for $200 and see it expire worthless. However, if that happens as the price of your underlying stock declines from your purchase price of $49 to (for example) $41, that can’t feel very good. Sure, instead of losing $800 on the shares, your loss is only $600 because you sold the option. But that is simply not good enough.

    What are you going to do now? If you refuse to accept the reality of a $41 stock price and want to sell options with the same $50 strike, there are two potential problems. if the $50 call is still available, the premium is going to be quite low. I hope that you did not adopt covered call writing with the intention of selling options at $10 or $20 when your initial investment is $4,700 ($4,900 less the $200 premium). Are you willing to write options struck at $45, knowing that if you are lucky enough to see the stock price recover that much, the result would be a locked in loss? The point is that the future becomes murky and knowing how to continue requires some experience as a trader/investor.

    The proper technique would have been to manage position risk once the stock price moved below a previously chosen limit.

  1. Implied volatility was recently quite high, but has declined by the time expiration day arrives. Option writers love it when implied volatility is well above its historical levels because they can collect a higher-than-normal premium when writing their covered call options. In fact, option premium can be so attractive to sell that some traders ignore risk and trade in inappropriately high number of option contracts (see discussion on Position Size).

    To get an idea of just how much the option premium can vary as implied volatility changes, see the article on volatility vs. option premium.

    Consider this scenario. You own a covered call position, having sold the $50 call on a stock currently priced at $49 when the stock market suddenly gets the jitters. That could be the result of a big political event, such as a presidential election or the possibility of Britain leaving the European Union (Brexit).

    Under customary market conditions, you are quite pleased to collect $150 to $170 when writing a one-month covered call. But in this hypothetical, high implied volatility scenario — with only 3 days before your option expires — the option that you sold is priced at $1.00. That price is so absurdly high (typically it is priced around $0.15), that you simply refuse to pay that much and decide to hold until the options expire. But the experienced trader doesn’t care about the price of that option in a vacuum. Instead, that more sophisticated trader also looks at the price of the option that expires one month later. In this enriched IV environment, he/she notices that the later-dated option is trading at $3.25. So what does our smart trader do? He/she enters a spread order to sell the call spread, collecting the difference, or $2.25 per share.

    The trade involves buying the near-term option (at the unattractive premium of $1.00 and selling the next month option at the very attractive premium of $3.25. the net cash credit for the trade is $225. That cash is the credit that you hope to keep when the new option expires worthless. Note that this is substantially higher than the normal income of $150 to $170 per month. Sure you may have to pay a “terrible” price to cover the option sold earlier, but the only number that counts is the net cash collected when moving the position to the following month  — because that is your new potential profit for the coming month.

Writing options and seeing them expire worthless is often a good result. Just be aware that it is not always such a good thing.

h/t: TheBalance

— The Option Specialist

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About the Author: The Option Specialist