Learning how to beat the Wizards Of Wall Street at their own game with options is similar to improving your golf game. You can’t get very far unless you unlearn your old bad habits.
With options, popular misconceptions have been advanced by many books and by social media.
Today, it’s time to slay a few option trading myths.
Table of Contents
Myth 1: Selling Options is Inherently Risky than Buying Them
Reality: Here’s some statistics to settle the debate:
85% of all options sellers make money.
The other 15% of the options buyers make the money; the other 15% of the options sellers lose the money.
Option buyers are mostly losers. Therefore sellers are the basic winners.
While selling options involves different risks, it can be less risky when coupled with proper risk management strategies.
When people hear the word ‘options’ they often break out in a cold sweat. They are usually thinking “Yeah I’ve heard of those, they are very risky’ or “I am sure I read something bad about binary options”.
The Dividend On Fire approach isn’t related to binary options. They were a form of gambling and have been banned by ESMA in 2018 and subsequently by the FCA in 2019. We don’t involve them here.
Options, when used correctly, aren’t overly risky. Most brokers won’t allow risky usage for beginners.
Selling unhedged options is the risky approach, which is uncommon in reputable strategies. At Dividend On Fire we advise against it, even if your broker permits.
Our strategies involve covered calls and cash-secured puts, both hedged, ensuring fixed and understood risk. Surprisingly, selling these options on a share is less risky than buying the share outright.
Yes, that’s right, the sale of the option not only brings in premium, but it also reduces the risk in owning the shares.
As you master option selling you realise the strategy can be used for income purposes or for adjusting the cost basis of shares you want to own.
Although there are still risks, selling options definitely operate in the shallow end of the equity risk swimming pool.
Myth 2: Options Selling is Only for Advanced Traders
Reality: Options selling can be accessible to traders of all levels. This is especially true with the availability of beginner-friendly resources and educational material which we try provide here.
This is the main reason I started to document my options journey with Dividend On Fire. It was to lay down a solid foundation for options traders to come. So they can read, learn, and ultimately become better equipped to navigate the world of options trading.
Myth 3: You Can Only Make Money in a Bull Market
Reality: Options selling can be profitable in various market conditions, including bear and sideways markets, not just in bullish trends. Options selling provides a unique advantage to traders by allowing them to generate income regardless of the market’s direction.
Throw at us a bull market, bear market or sideways market it does not matter. The true power of options selling lies in its adaptability.
Options selling is not limited to directional market movements. It thrives in sideways markets as well.
When the market moves within a range, option traders can capitalize on the lack of significant price fluctuations by selling both covered calls and cash secured puts.
The key takeaway is that options selling provides a versatile toolkit for traders to profit from various market conditions.
By understanding and implementing the right strategies, traders can create a consistent dividend-like income stream. This is irrespective of whether the market is bullish, bearish, or going nowhere.
This flexibility is what sets options selling apart as a powerful approach in the world of trading.
Option Selling Action Chart
|AVERAGE / HIGH
|Can profit if the market moves sideways, higher, or even slightly lower. Allows us to buy stock at a lower price
|Unlimited loss potential*
|AVERAGE / HIGH
|Can profit if the market moves sideways, lower, or even slightly higher
|Limited profit but unlimited loss potential*
*The risk of loss is because the underlying security can always go to zero. This is why, despite having high premiums, you should never sell options on risky stocks. This is a recipe for disaster.
Myth 4: It’s Not Suitable For Small Accounts
Reality: Capital requirements for options selling vary depending on the strategy used but it also depends on what stocks you want to trade options on.
I covered whether you can trade options with a smaller account size before so I won’t get in too much detail again.
The rub with a smaller account is that you are more limited to which underlying securities you can trade.
If you only have $10,000, you can’t sell a cash secured put on $AMGN for example, as this trades at $257 per share.
1 option contract = 100 shares = $25,570 capital needed to sell a cash secured put on Amgen Inc.
Diversification and position size is also a bit trickier with a smaller account. Instead of having a max position size of just 5%, you might have to contend with having a 10% maximum instead.
Myth 5: It’s Solely About Premium Collection
Reality: Successful options selling involves not only premium collection but it’s about being able to successfully adjust our cost basis per share on stocks we want to own long term.
Let’s dig a little deeper.
Selling options doesn’t have to be all about premium collection. You can focus on being a more value-based options investor.
Value investing + short term conservative option strategies = your personalised roadmap!
What does this mean?
Well, in my tax free ISA that I have but I can’t trade options in, the only chance to reduce my cost basis is by purchasing more shares when the stock price drops. This approach may not be the most effective for maximizing my profits but it’s the only tool I can use in my toolkit.
So, how do we get around this with options? By using the option strategies we preach at Dividend On Fire, you have the chance to reduce your cost basis regardless of market conditions. This has significant implications.
Maintaining a consistently lowered adjusted cost basis means minimizing or even eliminating losses in a declining market, gaining when the market is stable, and reaping even greater profits in an upswing.
Adjusted cost basis might sound, well, a bit boring. But it’s our secret sauce as value based option investors.
In essence, embracing the adjusted cost basis mindset allows you to consistently acquire stock you want to own at a discount and continue receiving ongoing dividend-like income.
The option strategies we use to do this are cash secured puts and covered calls.
Myth 6: It’s Not Suitable for Income Generation
Reality: Options selling is a popular strategy for income generation, as it allows traders to collect premiums, which can be a consistent source of revenue.
Don’t believe me?
These people live the reality of producing a consistent stream of income every single month from stock options trading.
Myth 7: It’s Only for Full-Time Traders
Reality: Options selling can be adapted to fit various schedules. Some strategies, like covered calls, require minimal time commitment. as Erica pointed out in her interview.
Depending on what timeframe you decided to trade options also plays in to how much time is needed.
I have found personally that weekly options do require a bit more management. Options that expire monthly generally are more hands off until perhaps the final 2 weeks before expiration. This is when I generally decide if I am going to let the option expire worthless, buy to close it, or roll it out to the following month hopefully for a net credit.
If you’re thinking about turning pro and becoming a full time options investor you might want to read Breaking Chains – Your Path Towards Options Trading Full-Time.
Myth 8: There Is Big Money To Be Made In Selling Overvalued Options (High Premiums)
Reality: The good news is that over 80% of the time, this statement is correct. You will make money selling overvalued options. The bad news is that the other 20% of the time can cost you far in excess of all the profits you’ve made. This is because when selling options your profits are strictly limited to the premium you receive.
However, your risk is not.
And over time, all markets make giant, unexpected moves.
Getting caught in one of these moves without a trading plan can wipe out months or years of profits.
Believe me, I’ve encountered this situation many times when selling puts on stocks with high implied volatility (IV) and juicy premiums. It can go smoothly until suddenly it doesn’t, and it can lead to significant losses.
Not only do you experience losses, but emotionally it can take a bit of time to get your confidence back.
So avoid chasing high premiums on stocks that you would never want to own in the first place.
Myth 9: Computer Programs Or AI Can Tell You How To Trade Options, Which Ones To Buy And Sell, And Which Strategy To Use.
Reality: With the rise of Artificial Intelligence, there are more and more tools you can use to help you trade options, choose strike prices, filter stocks by delta or by moneyness.
Even with advanced AI however, it is still not enough to analyse all the various factors that go into option trading.
When Gary Kasparov beat the super computer twice at chess in 1985 he remarked:
The computer was “fully aggressive” but that its “mind was too straight and primitive”
“Chess is much wider than just calculations. It’s even wider than logic. You have to use fantasy, intuition and some kind of prediction.” Kasparov said.
But, the computer does have some advantages: “We can lose hope. A computer can’t lose hope.”
Chess is no different than the skills necessary to be a successful options trader.
AI-powered tools should serve as valuable aids to traders, assisting in the evaluation of various strategies and numerical data
I’ve been using a tool called Copilot for a while now. Despite its monthly cost, it has more than justified its value, often yielding returns that are 40 times its cost each month.
Moreover, the creator is highly proactive and provides hands-on assistance in getting you fully set up. He ensures that you can promptly start identifying opportunities that align with your risk tolerance and begin generating income almost immediately. You can find it here.
In conclusion, mastering options trading is akin to refining your golf game – it requires unlearning old habits.
Dispelling common myths about options is crucial.
Remember, selling options, when coupled with proper risk management, can be less risky than commonly believed.
It’s not just for advanced traders; accessible resources are available for beginners to start today.
Profitability isn’t confined to bull markets; options excel in various market conditions.
Even with a smaller account, option trading is possible.
And finally, successful options selling is about more than premium collection; it’s about adjusting your cost basis for long-term gains.
So, armed with knowledge and the right strategies, you can navigate the world of options trading with confidence.