.I.P. 80% of Option Traders?

Another B.S. statistic! I put off trading options for years because I read someplace that over 80% of all options expire worthless. Expire worthless... something we're all afraid of. You don't want your tombstone to say: "Here lays so and so....he expired worthless." But seriously, many a potential stock option trader may have been scared away from the wonders of trading stock options by the 80% statistic by not fully understanding what that dismal statistic (some say it's as high as 90%!) really means. As the old saying goes, "there are statistics and then there are damn statistics". In the case, the famous 80% is a damn statistics. Here's why.

Option contract and open interest

An option contract is where one person buys (long) and another sells (writes); this transaction constitutes one contract. If the buyer and seller close out their positions, there is one less contract. If one original buyer sells their original position to another person, then the original contract would still be open; thus the name "open interest".

The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or a negative number. Most traders interpret that if open interest is increasing, more money is coming into the market for that instrument and usually means or verifies increasing prices. Conversely, if open interest is decreasing, it means that money is exiting the investment vehicle and usually means decreasing prices. Open interest and price is one way to confirm a trend. The following table is a well known description of the relationship of price, open interest and trend.

Price

Open Interest

Interpretation

Rising

Rising

Market is Strong

Rising

Falling

Market is Weakening

Falling

Rising

Market is Weak

Falling

Falling

Market is Strengthening

But how does that tie into the mysterious 80% worthlessness of stock options?

The myth

It has to do with two things: First, it has a lot to do with how options are pur-

chased. Most stock option traders seem to prefer buying out of the money calls if they think a stock is going to make an impending upward move in price. Out-of- the-money calls are cheaper than in-the-money calls. However, not all stock option traders trade that way. As in-the-money options have intrinsic value, they are normally closed out and not left to expire as they will have intrinsic value. However, as most options are purchased out-of-the-money they are normally left to expire because as they approach expiration, they quickly lose premium value which has only time value and no intrinsic value.

Secondly, many sophisticated stock option traders and portfolio managers use stock option puts for hedging purposes. They purchase out-of -the-money puts and if not exercised, they expire worthless. It's not uncommon that thousands of put options are used for hedged positions. Thus, given the open interest of out of the money calls and hedged puts, 80% of stock options expiring in a state or worthlessness might be accurate but it doesn't mean that 80% of stock option traders lose money.