MIAMI, Fla. (MarketWatch) — While researching my book, “Understanding Options,” I discovered that many people misunderstand options. Even worse, some experts make it seem like you need a Ph.D in mathematics to trade them, and some option books don’t help.
Option myths probably started in 1635 when Dutch investors bought call options on exotic tulip bulbs. Some people made paper fortunes without ever taking possession of the beautiful bulbs. When tulip prices collapsed a few years later, so did the Dutch economy, and the once valuable options became worthless. Many investors blamed options for their losses.
It’s not 1635 anymore, so let’s take a look at five of the most common option myths:
Myth #1: Options are too risky
This myth has survived for centuries because some people have misused options, and gave them a bad name. “Options were designed to be risk-reducing tools,” said Mark Wolfinger, author of “The Rookie’s Guide to Options.” “They are used to hedge risk, so the myth that options are too risky is not true. Options are risky if you don’t understand how to use them,” he noted, “but by themselves, options are not risky, although some strategies are risky. The real risk is with the options trader.”
In other words, you can design option strategies from conservative to risky, and in many cases, they are less risky than trading stocks. For example, one of the biggest advantages to investing in options is that you often know in advance how much you could lose if you’re wrong.
Myth #2: Options are difficult to understand
Options by themselves are not difficult to understand. Basically, you have the right to buy or sell an underlying stock at a designated price. Even better, there are only two options: a call and a put, and you can either buy or sell. “If you’ve ever gone to the grocery store and received a rain check when they were out of a product, you used call options,” Wolfinger said. “If you ever bought an automobile insurance policy, you bought put options.”
The difficult part is that options can be used in extremely complex strategies with sexy-sounding names. If you’re a beginner, it’s best to stick with relatively simple strategies such as selling covered calls on stocks you already own.
Myth #3: It’s easy to profit buying options
While some think that options are too difficult, others believe it’s easy.
“It’s extremely difficult to make money buying options,” Wolfinger said. “First, you have to get the market direction right, and many people believe they can do that, but the majority can’t. Also, the timing is difficult. Options have a limited lifetime, and once they expire, they are worthless, so your stock has to move in your direction quickly. If it were that easy to make a profit trading options, then everyone would be rich.”
One of the most common mistakes made by rookies is buying cheap out-of-the-money options. They are attempting to turn a small amount of money into a huge windfall. Because the options are out-of-the-money, the time remaining before the options expire becomes critical. The stock must make its move before expiration for them to work in your favor.
“It’s foolish to buy out-of-the money options,” Wolfinger cautioned. “You’re going to lose far more often than you will win, but people think of them as mini-lottery tickets and hope that the occasional win will be huge.”
Myth #4: Selling options is like receiving free money
There’s an incorrect belief that selling options is nearly risk-free. “Although selling options to collect cash looks safe,” Wolfinger said, “selling ‘naked’ or uncovered options is a risky strategy because there is unlimited risk.” Wolfinger said that while option sellers can win most of the time, the occasional losses can be devastating when inexperienced investors don’t manage risk properly.
On the other hand, selling covered calls reduces risk because you already own the stock. “What you lose is the opportunity to make a pile of money,” Wolfinger said about covered calls. “It may result in a lost opportunity on a big rally, but that is not a loss. And if the stock tumbles, the covered call owner loses less than the stockholder.”
Myth #5: Options are the cause of stock market crashes
Whenever there is a stock market crash, many people blame it on option traders (or short-sellers). “Options did not cause the credit default swaps or mortgage problems,” Wolfinger said. “It was greedy bankers and traders taking a gigantic amount of risk, and yes, you can use options and other derivatives products to take as much risk as you want.”
Because many bankers had no personal downside risk, they traded way more size (40-to-1 leverage in some instances) than was appropriate. “They got in over their heads and didn’t think they could lose,” Wolfinger said. “By taking on too much size, they got into trouble, but it wasn’t the fault of options.”
To understand options and dispel many of these myths, it’s essential to get an education. Buying books, reading online articles on your brokerage firm’s Web site, or taking free or inexpensive classes through the Options Industry Council (OIC) and the Chicago Board Options Exchange (CBOE) is a good start.
It’s also recommended that you avoid attending expensive seminars (some charge as much as $3,000 a class) that promise quick profits using secret strategies.
After all, another myth is that someone has a secret. The only secret to making profits in the options market is hard work, discipline, having a plan, and learning how to accurately price options.
Michael Sincere (www.michaelsincere.com) is the author of “Understanding Options,” “Understanding Stocks,” and “Start Day Trading Now.”
