…if held to maturity. Of course, while many buyers of call options will exercise or sell their options before expiry if the options trade in-the-money, let’s pretend for this discussion that one holds the option until expiry.
Michael James on Money mentioned that he thinks it is generally a bad idea for the average investor to buy options, and I would be inclined to agree. Long options (long means you buy something, short means you sell it) can offer tremendous leverage which means you magnify the risk and return. It is estimated that approximately 80% of call option contracts, if held to maturity, will expire worthless.
But let’s look a little more closely at a real world example. I’ll use Royal Bank as an example since it is very liquid, but this is not a recommendation to buy, sell, hold or not hold Royal Bank stock or options.
At the time that I am writing this post, RY (ticker symbol for Royal Bank common stock) is trading for $44.33 per share. There is an August 2008 Call Option on RY with a $50 strike price which last traded for $0.30. If you were to purchase this call option your outlay would be $30.00 ignoring commissions (option contracts are for 100 shares). If RY trades above $50.01 at expiry, then you would exercise your option (or sell it) since it would now be trading “in the money”. You wouldn’t realize a profit unless RY traded over $50.30. If RY trades for $50.00 or below at expiration, then you would just let the option expire worthless and you will have lost your initial $30 forever.
Because there is only 32 days until expiry and RY shares would have to appreciate by 12.79% (which would normally be a rare proposition for RY historically), there is not much value in these options, hence the relatively cheap price of $0.30 per share. The option market is predicting a volatility of 29.61% for this 32 day period for RY – which equates to the market’s expectation that the probability of this option ending up in the money is only 7.2% (according to an option probability calculator).
But what about a $50 call option with more time, i.e. a $50 call option that expires in January 2009. In this case we have 184 days until expiry instead of 32. You would think that since there is more time, there is more of a chance that the option will end up in the money. The option market believes that the volatility of RY during this period will be slightly lower at 27.48% (which when taken with the higher implied volatility during the next 32 days indicates that the market thinks RY will become less volatile over time). According to the option probability calculator, there is a 25.6% chance that this option will end up in-the-money. But this doesn’t mean much until we know the price of this longer duration option. As it happens, it last traded for $1.85, which means your outlay would be $185. Even though this option has the same strike price of $50 it is worth more since there is more time for RY to hit $50.
Let’s now turn to a more volatile stock, RIM (Research in Motion). Again, this is not a recommendation to buy, sell, hold or not hold RIM. Randomly selecting a call option I picked a December 2008 $150 call option. RIM, at the time of writing, last traded at $115.26. Based on the market’s implied volatility of 50.60%, there is an estimated 17.9% chance that this option will end up in-the-money, which is line with the rule of thumb that 80% of call options if held to expiry will expire worthless.
Implied volatility requires more explanation, but it will need a few posts and I will tackle it when I get back from my trip. In the meantime, consider that when you just buy 100 common shares of RY, the chances of you losing all your money during the next 32 or 184 days is pretty remote. Perhaps your expected range of returns would be between -15% and +15%. Conversely, if you bought the options you have an 80% of losing all your money and only a 20% of making a lot of money if held to expiry.
Thanks for the link. Because of my interest in math and finance, I was able to understand your discussion of implied volatility. This post is probably a good test for potential option investors. They should have to learn enough that they can understand what you said before trading.
Hi,
I’m glad you mentioned that ‘80% of options held to expiration expire worthless.’ That 80% is figure is quoted frequently, without your disclaimer. It’s a very misleading number. No one knows for certain, but many of the options that have any intrinsic value are closed prior to expiration. Thus, the options held all the way tend to be worthless. Bottom line: nowhere near 80% of the options written expire worthless.
I’d like to clarify another point. If you hold an option until expiration, the price you paid is 100% IRRELEVANT when it comes to deciding whether to exercise an option. In your example above, if the stock finishes at 50.29 no one would allow it to expire worthless. Even if you paid a whole lot more than $0.30 when you bought the option, why throw away that $29 of intrinsic value? Why lose every penny you paid for the option when you can salvage $29?
RIMs probability of finishing in the money has noting to do with that 80% figure. It’s 100% related to the stock price, time remaining, and implied volatility.
One last point: If an option has a 20% chance of finishing in the money, the chances of making a profit are less than that. Part of the time the option does not move far enough in the money to compensate the buyer for the premium paid.
http://www.mdwoptions.com
http://blog.mdwoptions.com/options_for_rookies/
@Mark – Thanks for pointing that out – brain fade on my part as I knew that but didn’t do a good job proofing my post (re: not exercising the option) – I’m out of town and have a number of posts pre-written (which I wrote all in one sitting- not that it’s a good excuse for being sloppy).
Thanks for your contribution. Although I have a question about the RIM example- you mention that it finishing in the money is 100% due to price, time and implied volatility. Isn’t implied volatility just the “implied” volatility based on the price of the option?
Cheers
I realize that options are risky. It’s ironic that level 1 options which allows you to only lose your premium discourages most options beginners right off the bat.
IMHO, if you can progress to level 3 or 4 options then your chances of making money might be greater. You would be collecting the premiums of buyers and sellers instead of relinquishing them.
If you don’t have a full time job and can sit by the computer all day than investing in options IMHO is ok for between 5-10% of your portfolio. If you can admit when you are wrong and limit your losses than investing in options is acceptable.
IMHO, it;s like investing in the xgd or in risky venture stocks. Limit options to 5 % of your portfolio and you should be fine.
I read a good book on options by Micheal Thomsett and a good book on options put out by the montreal exchange. Again, just my opinion. Best Regards—Joe
@ Joe – you will be interested in an upcoming interview to be posted here that I had with someone who was a market maker for options on the Chicago Board of Options exchange. Stay tuned… :)
I’m glad that you and Mark pointed out that 80% HELD to EXPIRY detail… very important.
I’ll add that SOME options you actually would be very, very happy if they expired worthless. These are those situations:
1) If the option was shorted by you, as in the case of writing a covered call or a ‘naked’ put, or:
2) The option was not meant for profit but as a hedge, as in a spread or a married put.
In the first case, the happening of an option expiring worthless is a relief. It represents the end of an obligation, and that the money received for taking on the obligation has been successfully ‘banked’.
In the second case, it may be that the option expiring worthless is a GOOD thing that may be chalked up to the cost of doing business.
For example, if an investor were to buy XYZ at $50, and as a hedge also buy an XYZ June $55 put for $7.50, his total cost will be $57.50.
Should XYZ go to $70, the profits would be ($70 – $59) = $11, or 19.13%. The stock alone was a 40% gain, but the put has expired worthless,
On the other hand, if XYZ falls by 40% or so, the put option will stop our investor’s losses right at his total cost minus the strike price, or ($57.50 – $55) = $2.50, or a 4.34% loss.
I believe that in the above scenario, reasonable folks would be much happier surrendering half of their gains if it meant limiting their losses to such a miniscule amount in the case of disaster.
At the prospect of losing 4.34% or making 19.13% on the same size movement in the stock, allowing one’s put option to expire worthless would actually be something to hope for.
Options only expire worthless if you let them. There is nothing saying that there cannot be zero open interest on a certain strike price at expiration, meaning no open positions exist. Investing by design is a negative sum game, in options as well. Nothing is created, money changes owners, while brokers take their cut as commission. The ones who profit utilize combination of strategy, technical analysis and a dose of luck. The ones who lose are the uninformed, the inexperienced and the unlucky. But the brokers always get their commissions from both buyers and sellers, and that is where the real risk free money is at. Most brokers don't trade their own accounts because they know the game is rigged, they prefer the other fools to take the risks, while they take a cut as commission every time somebody buys or sells.