Do Most Options Expire Worthless? (Part 3)

In Part 1 I presented Summa’s notorious option myth and in Part 2 I presented its debunking. Today I bring in one more voice of reason.

If you have spent time in the option education circles then you’ve probably heard of Brian Overby. Overby has given many presentations on different option topics and he has also authored a book on option trading. He is or has been Senior Options Analyst and/or Director of Education for TradeKing brokerage. I feel being associated with a prevalent brokerage house like TradeKing gives Overby some credibility. I think he’s less apt to spread fictional/fraudulent claims because the reputation of his employer hangs in the balance. This is no guarantee (e.g. Peregrine Financial Group) but…

Addressing the question what percentage of options get exercised, Overby writes:

      > the correct answer is this: according to the Options
      > Clearing Corporation’s 2006 trading year results…
      > around 17% of all options contracts opened got
      > exercised. About 35% expired worthless, and almost
      > half (48%) of the rest got bought or sold to close
      > in the open market.
      >
      > If these numbers seem surprising go back to the
      > basics of option for an answer. It’s easy to lose
      > sight of the fact that an option is a contract. We
      > often think of options as hot potatoes that get
      > passed around until they wind up in someone’s hands
      > at expiration. But actually, if an option contract
      > gets closed in the marketplace, it just ceases to
      > exist and will therefore never make it to expiration.

I think we can pretty much put this option myth to bed. No, most options contracts do not necessarily expire worthless and no, this is certainly no reason to sell option contracts. We may come up with other reasons but certainly not this one.

Do Most Options Expire Worthless? (Part 2)

In the last post I detailed what I believe to be the root of this notorious options myth. Today I bring some critical analysis to the party.

I’m going to let some other writers do the heavy lifting. Let’s begin with this:

      > A common claim is that 90% of options expire worthless,
      > and that therefore it is better to be a seller of options
      > than a buyer of options. This claim misstates a statistic
      > published by the Chicago Board Options Exchange (CBOE),
      > which is that only 10% of option contracts are exercised.
      >
      > But just because only 10% are exercised does not mean
      > the other 90% expire worthless. Instead, according to the
      > CBOE, between 55% and 60% of options contracts are
      > closed out prior to expiration.

So here’s the rub: did the CME data showing 75% of all options held to expiration expired worthless mean 75% of all options expire worthless? Not necessarily. We would need a breakdown of options held to expiration vs. options closed out before expiration.

Continuing on:

      > So if 10% of options contracts end up being exercised,
      > and 55-60% get closed out before expiration, that leaves
      > only 30-35% of contracts that actually expire worthless.

30-35% vs. 75% is a big difference and that, evidently, is what makes this such a big option myth.

Here is another post on the subject:

      > It comes in several flavours, sometimes stated as 80%,
      > 90%, or whatever. It is the maxim that most options
      > expire worthless. It is repeated so often out there
      > in the marketplace, it is taken as a given and used as
      > a justification to be a nett [sic] seller of options and/or
      > promote option selling @education”. It is repeated,
      > as a mantra, by some of the most well known folks in
      > optionland. There is only one problem, it’s bullshit.

Love it! It’s a compelling argument, too. I found a forum post from 2008 that read:

      > Summa is a proponent of selling options, so at the
      > very least he has a vested interest in putting forth
      > the conclusions of this study which has lent
      > credence to his book for years.

So if it is indeed “bullshit” then now we have an underlying motive for his writing it in the first place…

Do Most Options Expire Worthless? (Part 1)

In my opinion, one of the more devious option myths of all time is that most options expire worthless.

Based on my research, here is an article detailing the original findings. You can also do an internet search for the author’s report entitled “SELLERS VS BUYERS: WHO WINS? A STUDY OF CME OPTIONS EXPIRATION PATTERNS.” In this blog mini-series, I will therefore be talking about the article and the report, respectively.

I will start with the report since it was written one year earlier in 2002. From the introduction:

      > Three key patterns emerge from this study: (1) on average, three
      > out of every four options held to expiration end up worthless;

Jumping ahead to the conclusion:

      > Data presented in this study comes from a three-year report
      > conducted by the CME of all options on futures traded on the
      > exchange. While not the entire story, overall the data
      > suggests that option sellers have an advantage in the form of a
      > bias towards options expiring out of the money (worthless)
      > [italics mine].

I will now take a closer look at the article, which begins as follows:

      > While there are certainly many viable options-buying strategies
      > available to traders, options expiration data obtained from the
      > CME covering a three-year period suggests that buyers are fighting
      > against the odds. Based on data obtained from the CME, I analyzed
      > five major CME option markets… and discovered that three out of
      > every four options expired worthless….
      >
      > …Three key patterns emerge from this study: (1) on average, three
      > out of every four options held to expiration end up worthless;

Scrutinize these passages very closely. Do you see any difference between paragraphs of the the report/article? Do you see any difference between the content of the report and the article?

In the next post I will detail the mythological aspects of this content.