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Q:  Everyone tells me that 90 percent of options end up worthless upon expiration. If that’s the case, how does anyone ever profit?

A:  Lind Plus Senior Market Strategist Bill Dixon answers.

This seems to be one of the most common misconceptions of those new to options trading, and I have found that 90 percent figure you often hear to be incorrect.  For one thing, speculators tend to offset their options positions before the date of expiration even arrives.  "American style" options, which are most common in U.S. exchange-traded markets, are tradable instruments and can be closed out prior to expiration at a profit or loss.  According to data from the Chicago Board Options Exchange (CBOE) Options Institute, approximately 10 percent of options are exercised, and 50-60 percent are traded out in the marketplace prior to expiration. Normally about 30 percent of options expire worthless in each monthly cycle.

Believe it or not, it is also very possible to trade with only a 10 percent success rate and still be profitable.  If you are able to keep the losing trades (however plentiful they may be) to small losses and let the winners ride, you may find options trading can be a very profitable venture.  However, I think it is fair to say that most options traders hope for a better success rate than 10 percent. So the question remains, how can I increase my chance of success trading options?   

One of my favorite responses to the 90 percent myth is: “Then why don’t you sell them?” I should first note that many short option strategies pose substantial risk and certainly are not suitable for all investors.  With that in mind, it is one of my most preferred ways of participating in the futures markets.   A key reason is that by selling options, you are collecting time premium, which is constantly dwindling. 

Another attraction to selling options is that you’re able to pick and choose where you would like to be long or short. Let’s assume you were bullish corn, thought it was near a bottom, but you were a bit nervous to initiate a long futures position at the current levels with a downtrend still in place. By selling a put (the right to be short from a given strike price) you can collect a premium. This gives the buyer the right, but not the obligation, to be short from whatever strike price you, the seller, choose. 

Let’s say you decided to sell a put 20 cents below the current price and collect a 10-cent premium in doing so.  At this point your mindset is that if corn rallies, the value of the put you sold decreases. You can either wait for it to expire worthless or offset once you’ve achieved a desired profit. If the market trends sideways as time expires, the option should lose value and will expire worthless as long as the underlying futures price remains above the option’s strike price. If upon expiration the futures are trading below your strike, you will be exercised into a long position from that price. Keep in mind that you did get paid to take the risk, so as long as the futures settle within the 10 cents you collected below the strike, your trade is still profitable.

As much as I like employing short option strategies, long option strategies tend to present greater profit potential than most short strategies. By selling options, your profit potential is limited to the premium you collected, which means the option buyer’s risk is limited to the premium paid. On the other hand, the seller’s risk is unlimited when selling calls, and down to a price of zero when selling puts. Therefore, call buyers have unlimited profit potential, while those purchasing puts have profit potential on a fall to zero. 

Impact of Volatility
Another thing options traders follow closely is volatility. Volatility, like the amount of time before expiration, is very important in the pricing of options. During times of high volatility, sellers are taking on greater risk and wish to be compensated for it. As a result, buyers must pay higher premiums to initiate positions.  When volatility is relatively low, options are much cheaper. Unless the sellers are content applying their same strategies for lower premiums, they must compensate by doing one of a few things.  One is that they can sell strike prices closer to the actual underlying price than they normally do.  Another is to sell options with longer periods of time before expiration. This, in my opinion, gives the advantage to the option buyers. Now they can pay the same amount for a strike price considerably closer to the underlying futures price than they could in the past. Now the market doesn’t need to move quite as far as it would have in the past in order for the buyer to profit. 

Of course, you need to determine the right strategy for your goals, risk-tolerance and account size. Feel free to call me if you have any questions about this topic, or need assistance applying these concepts to the markets.

Bill Dixon is a Senior Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted division. He can be reached at 800-445-0567 or via email at bdixon@lind-waldock.com.  

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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