Option Contracts

The Smart Profits Report: Issue #297
Tuesday, April 4, 2006

Options Contracts: An Options Myth Unraveled - 90% Of Contracts Don’t Expire
By Jim Stanton
Advisory Panelist, Mt. Vernon Research

Many of you have, no doubt, heard the oft-repeated claim “90% of all option contracts expire worthless.” That statement alone should keep any sensible trader from buying puts or calls.

But we’ve done some research and the reality is far different. While 80%-90% of option contracts that are held until expiration do become worthless, only 30% of all options are held until expiration. Another 60% are sold or offset, and 10% are exercised. This means that 25% of all option contracts - not 90% of them - expire worthless.

That finding should bring some comfort to options buyers. But it does not mitigate the risk in the options arena.

Trading Option Contracts Is Not the Lottery

In my view, successful option trading depends on two factors: the strike price and the timeframe.

If you’re looking to hit home runs with option contracts in the market, try the lottery. Many novices buy some of the least expensive, out-of-the-money options, which expire three weeks later, in a quest to hit one out of the park. This strategy pays off every so often. Over the long run, though, these consist of the majority of contracts that become “worthless” at expiration.

When buying cheap, out-of-the-money calls, time is our fiercest enemy. Every day, even if the underlying stock is unchanged or up a fraction, the time premium is slowly slipping away. As time goes by, our fear of losing more money increases. That fear can cause sleepless nights and make us do odd things, such as selling the option contracts to salvage what we have left just before it becomes profitable. Being right but losing money is one of the worst feelings an option trader can experience.

Don’t Watch $400,000 Vanish

I made all of the normal mistakes when I began trading options. But losing money and sleep, along with selling some puts for a slight loss (the fear factor) two days before I could have made over $400,000, has changed the way I play the options market.

My technique begins with simple technical analysis of the underlying stock. This can be as easy as determining the overall trend of the stock using 50- and/or 200-day moving averages, along with support and resistance levels (previous highs or lows, moving averages, retracement levels, etc.).

The essence is to buy a call as close to support as possible, or buy a put as close to resistance as possible. That way, your risk is minimal because a break below support or above resistance gets you out of the trade with a reasonable loss.

Once I’ve declared my option strategy, choosing the strike price and time to expiration are paramount. Time decay is one of my main concerns. So, I look at the options chain to determine which in-the-money-option with little or no time premium is closest to the price of the underlying stock. Below is a daily chart of Safeco (Nasdaq: SAFC).

Safeco daily chart, April 4, 2006
Chart Courtesy of Trade Navigator Software (http://www.genesisft.com)

In late January, SAFC triggered a sell signal and the RSI (relative strength) fell below 50. It then dropped below its 50- and 200-day moving averages. The stock could not make much headway after reaching its February lows, despite a strong showing by the Dow and S&P. So, I looked for a spot to buy some puts.

On March 19, SAFC traded up to its 50-day moving average and the RSI was close to the 50 line (bullish above, bearish below). The stock was trading at $52.70 and the April $55 put was $2.30-$2.60. Although I did pay a 30-cent time premium, the leverage was much better than buying the April $60 put.

Less Liquidity With In-the-Money Option Contracts

The only problem with playing in-the-money option contracts more than one month out is that the liquidity can be low. That can mean a large spread between the bid and ask. In cases like that, you may have to choose an option that is not ideal. All we can do is use the best strategy available.

I made this trade 11 days ago. My exit point would be a break above $53.50, which would produce about a $1 loss. But if it reaches my target of about $49.40, it should produce more than a 100% gain.

Needless to say, I have not had trouble sleeping.

Good Trading,

Jim

Today’s Smart Profits Cribsheet

We’ve learned that 90% of options do not, in fact, expire worthless, but that short-term, out-of-the-money contracts usually do. So, why not sell them? Selling these options is a great way to generate some income by taking advantage of the options buyers with the false expectation of hitting home runs. Smart Profits #255, Out of the Money Options: Buyer Beware, Seller… Take The Money by expert panelist Lee Lowell, covers this strategy in detail.

And if you haven’t looked into Lee’s special electronic report, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks, now is a great time to do so. It’s a handbook that can be e-mailed right to your inbox.