WALL STREET GIBBERISH, 2007 FOURTH QUARTER NEWSLETTER

I use this section to present claims that are correct but misleading and possibly harmful to your investing experience. You may have heard or read that buying options is not a good idea because very high percentages, 80 to 90, of them expire worthless. With proper qualifications that is literally true, but it does not tell us anything about the wisdom of buying or selling options.

First, here is a very brief description of options. They come in two basic types: calls and puts. A call option gives the buyer/owner of it the right to buy a stock, index, or future at a specific price, called the “strike price” until it expires, which can be very soon or possibly two or more years in the future. A put option gives it holder the right to sell a stock, index, or future at its strike price until it expires. The seller of the option receives some money, called the option premium, from the buyer. The transactions are handled by brokers and through an options clearing agency so they can be traded like stocks.

If the stock or other underlying instrument is lower than the strike price of a call option when the option expires, it expires worthless. Similarly, if the price of the underlying is above the strike price of a put, it will be worthless upon expiration.

The claims made about the percentage of worthless options imply that just about all options purchases lose money. One reason this is not true is that both and calls and puts with same strike price are purchased. There are usually more of them at the strikes that are the closest to the value of the underlying. Unless the stock index closes at exactly the strike price at expiration, either the puts or calls will have value.

To the extent that more options are purchased for speculative purposes—calls with strikes (far) above the current price or puts with strikes (far) below, more than half of options purchased may end up worthless if held to expiration or lose money if sold before expiration. However, options can be used to take both very speculative and quite conservative positions.

An ad for a book about selling options proclaims “80% of all options held through expiration will expire worthless” and that is an honest representation. The key words are “held through expiration.” Options that have value near expiration usually are not held. For example, someone owning a stock may sell call options on the stock, a so-called “covered call.” If the stock is higher than the strike price near expiration, the seller of the calls may buy them back if the desire is to continue owning the stock. The owner of the call options may decide to exercise them by paying the strike price and buying the stock, which often happens just before an ex-dividend date because the call owner wants to collect the dividend. If the owner of a call that has value does not want to own the stock, he or she will just sell the call. In these cases the option is not held to expiration.

Puts are sometimes purchased as insurance so that the owner of the stock can sell it at the strike price if it goes lower before expiration. If the investor wants to keep the stock, the put will be sold to “collect” on the insurance. If owning the stock is no longer desired, the put may be exercised before expiration so that money may be taken in. Puts bought for speculative purposes that have value are almost always sold before expiration because not to do so would leave the put owner with a short position upon expiration and exercise of the option.

What this all means is that most, but not all, options that have value are not held to expiration. They can be offset through a sale or purchase depending on whether one is long or short the option or they are exercised. The options that are held through expiration tend to be the worthless ones since letting them expire without value is the easiest course of action and avoids paying a commission.

The bottom line is that the high percentage of options that expire worthless tells us nothing about the wisdom of buying or selling options. Both can be good strategies depending on one’s objectives. I do both in personal accounts. Usually I buy options for aggressive purposes, but occasionally for “insurance.” I will sell put options on stocks I am willing to own in order to either buy the stock at a lower price that it is currently trading at or to make some profit on the stock if it rises and the sold puts expire worthless.

I have also traded options to a limited extent in client accounts, usually in a conservative manner. Fidelity’s high option commissions made that impractical in most cases. Since the commissions at brokersXpress are quite reasonable, I am able to do more options trading if suitable for your investment objectives. Although options trading is often thought of as speculative, positions can be taken across the entire conservative to aggressive spectrum. Please get in touch with me if you want to explore the options (groan!).

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