Myth #3: Inexpensive Options are Cheap Options

The inexpensiveness of the options may be alluring inexperienced traders into thinking they are cheap, thus an obvious buy. The reality is just because an option is inexpensive, it doesn’t mean it’s cheap.

For example, on April 26, BAC was trading around $9.40 and the May 12.50 calls were trading at $.37. There’s no doubt that $.37 for an option is inexpensive, but is it cheap? Well, let's look at the facts. We have a mere three weeks to expiration and BAC would have to rise to $12.87 just for you to breakeven (assuming you hold to expiration). That’s a 37 percent move in a very short period of time. This suggests that the 12.50 calls are trading at a very high-implied volatility, as an option trading for $.37 that far out-of-the-money with three weeks left would have to be. Under a lower-volatility scenario, those 12.50 calls may only be trading around $.05. So the bottom line is you can’t look at an options price to determine if it’s cheap. You have to take into account its strike price, time to expiration, and current levels of implied volatility. Oftentimes when implied volatility is pumped up too high, inexpensive out-of-the-money options can rise to unjustifiably high prices.

The most inexpensive options you are going to find are short-term, out-of-the-money options. Statistically speaking they have the lowest probability (versus longer-term ATM or ITM options) of being worth anything at expiration. These options are priced inexpensively because they are a low statistical bet. Thus, if you decide to buy them, you better be sure the stock has the ability to reach the strike price prior to expiration. Remember, the options market is quite efficient so don’t think that you are getting a steal of a deal if an option is ostensibly cheap.

In an introduction to economics class I took in college, I was introduced to a phrase that sheds some light on this scenario: “there’s no such thing as a free lunch.” The options market does not have a track record of handing out freebies. For everyone buying an option, there’s someone on the other side of the table selling it to them. Odds are if the option was such a great deal (read: too inexpensive), then option sellers would be asking more for them. So don’t be too quick to think that those selling these ”inexpensive“ options are idiots...you never know, the idiot may just be you.

Myth #4: Options are Riskier than Stock

Due to the myriad of strategies one can trade with options, it is impossible to make a general statement that options are riskier than stock. It depends completely upon how you use options.

Options are merely tools. Although some use them to speculate or take on risk, others use them to reduce or hedge off risk. Due to the leverage inherent with options, it is quite easy to blow up an account when they are used improperly. This option myth is probably fueled by the occasional inexperienced option trader who loads up on an exorbitant amount of call or put options in an effort to amass large profits. All too often these traders lack any semblance of a sound money-management plan and blatantly disregard the drawbacks of leverage. In short, they commit financial suicide.

Are there certain scenarios where trading options could be considered more risky than stock? Absolutely. One such scenario will be explored in a minute. But there are also a plethora of situations where options can be used to reduce risk (covered calls and protective puts being two obvious ones).

Suppose I'm bullish on IBM, currently trading at $107, and am considering buying 100 shares of stock. My total capital outlay would be $10,700. The theoretical risk would be the entire $10,700 (this is of course assuming you would be foolish enough to ride the stock all the way to zero) and the potential reward is unlimited.

Scenario #1: The SMART idea

Instead of tying up $10,700 of capital to control 100 shares of stock, I could buy one October 105 Call for $880. This call option gives me the ability to control the same 100 shares of stock at a drastically lower cost. I then have the option of using the other $9,820 in whatever manner I want. I could merely place the cash in an interest-bearing account for the duration of the trade, or use it for other strategies. Because my maximum risk is $880, this is a scenario where using options is much less risky than buying stock.

Scenario #2: The STUPID idea

Instead of using the $10,700 of capital to buy 100 shares of stock, why not just use the same $10,700 and buy as many call options as possible? At $880 a pop, I could buy around 12 contracts ($880 x 12 = $10,560). Some erroneously assume that since they are paying the same amount of money, they have the same amount of risk. WRONG! To lose the $10,700 in the stock trade, IBM must fall to $0. To lose the $10,700 in the option trade, IBM only needs to reside beneath $105 at August expiration. There is a much higher chance of losing your money in the call-option trade. Furthermore, by buying 12 contracts, you now control 1,200 shares, not 100.

Scenario #2 presents a good example of how an improper use of options and their leverage can present more risk than buying stock outright.

Bottom Line: It's fair to say that the biggest risk of all is ignorance. With proper education and application, options serve as superb vehicles for minimizing risk and are indeed less risky than stock.