We're going to make a little wager with you.
The next time you're talking with a group of "informed" investors, bring up the topic of options trading. Before long, someone in your group will cite the well-known statistic that more than 90% of all options expire worthless.
And most of the other folks will nod in solemn agreement.
All the experts want us to believe that options are to retail investors what Kryptonite is to Superman.
Because of that the "90%" stat is presented as trading gospel and is cited over and over and over again - in speeches, in magazines, and in investing analyses of every type.
There's only one problem.
It's just not true.
In fact, it's one of the biggest investing myths of all time.
And one of the biggest investing tragedies - since the folks who accept this trading tall tale are missing out on one triple-digit trade after another.
In this special Q&A session, The 10-Minute Millionaire's D.R. Barton, Jr., busts this myth wide open. And he shows us how to cash in on the simplest and most powerful options trading strategy you'll ever find.
D.R. recently detailed his options strategy to Money Map Press Editor William Patalon, III.
Here's a partial transcript of their talk...
William Patalon, III: D.R... you and I are talking here to, in essence, "bust the myth" about options trading... to blunt the belief that trading options is the stock market equivalent of a "fool's errand."
In fact, just the opposite is true... isn't that right?
D.R. Barton, Jr.: That's right, Bill. Traded correctly - with the right underlying "mindset" and with the correct trading system - options are certainly the quickest and most powerful way to string together the windfall wins that will put you on the path to your first million dollars.
WPIII: And with lower risk.
DRB: (nodding) With lower risk - especially relative to potential reward.
WPIII: Let's go through all of this... because it's a conversation you and I have had many times... and I'm betting folks will find it as fascinating - and as downright surprising - as I did.
DRB: Fire away.
WPIII: And let's start with the obvious.
There's a good reason the idea of trading options terrifies so many investors: The statistics that are often bandied about make it seem like a losing proposition.
DRB: That's exactly how it appears.
But it's a myth... and a myth I can "bust"... fairly easily.
Let's start with the myth itself...
A few years back, the Chicago Mercantile Exchange (CME) did a very detailed study looking at options. It looked at expiring and exercised options over a period of three years - 1997, 1998, and 1999 - and found that an average of 76.5% of all CME options held to expiration expired worthless.
WPIII: Out of the money...
DRB: Yes... out of the money... worthless.
And this was a pretty consistent finding - across all three years - with 76.3%, 75.8%, and 77.5% expiring worthless, respectively.
WPIII: So, from this general level, we can say that for every option exercised "in the money" at expiration, there were three options contracts that expired "out of the money" - hence, worthless.
That means option sellers had better odds than option buyers for positions held until expiration.
At least, as far as this goes...
DRB: That's right, Bill.
And here's where all of this gets very, very interesting. And where investors who accept this "story" about the pointlessness of options trading are missing the powerful potential of this trading strategy.
WPIII: And this story gets interesting because...
DRB: Because of several key realities.
First, let's talk about the numbers and the fact that the "picture of futility" that the CME data represents is based on holding options to expiration. But we're traders... so, by definition, when we buy options, we never hold them until expiration.
Second is the fact that many folks treat options as "lottery tickets." People buy options that are really, really far from the current price - which, in the vernacular of trading, is referred to as "deeply out-of-the-money options." They do this because the options are cheap in price. And because they're "longshots" - meaning that, if they hit, they hit big. That's their allure. But it's also their weak point. Like most longshots, these don't pay off: Practically all of these lottery-ticket style options expire out of the money. And worthless.
WPIII: And that drives up the overall percentage of options that expire worthless as reported by the study.
DRB: Exactly, Bill. And that brings me to a point worth underscoring. These numbers are "averages."
And successful trading strategies don't focus on the averages.
They focus on specific opportunities. On probabilities. And on managing risk.
WPIII: Let's start with the "opportunity" concept.
DRB: Totally agree.
You see, one of the true advantages of options is something called "leverage."
Ask most investors to define the term "leverage" and they think of debt, of exacerbated risk.
WPIII: But you view that concept very differently, don't you? This is something you and I have - only partly in jest - referred to as "The Archimedes Trading Academy." (D.R. and Bill both laugh)
DRB: That's right, Bill.
I'm not talking about leverage as in debt. I'm talking about leveraging opportunities.
Options allow a trader to "control" a big block of shares, of bonds, of currencies, of commodities - for pennies on the dollar.
Just look at the word "leverage" itself.
If you take the "root" of the word, you have the word "lever."
Archimedes, the Greek mathematician and engineer, once said, "Give me a lever and a place to stand and I will move the earth."
With my system, investors who have limited amounts of money and limited amounts of time can use options to achieve pretty much the same result.
Used as we do, options are like a lever that makes it easy to move large amounts of wealth... from the other players in the "market" and into your trading account.
WPIII: You've told me that options are the "lever"... and your 10-Minute Millionaire trading system is kind of like the "fulcrum."
DRB: That's exactly how I view this. You see, Bill, I use options to "leverage opportunities." You can use small amounts of force (small amounts of capital and small amounts of time) to move large amounts of wealth.
WPIII: And what's really striking is that you're able to do this - even if the market or the stock you're trading is making very small moves.
DRB: Yes. Leveraging an opportunity is critical. That's because - if we use the natural monetary leverage of options - we can find trading opportunities with high probabilities for quick moves and make big returns... with only a modest move in the stock or index we're trading.
WPIII: And when you say "big returns," you're even talking about the potential for triple-digit returns.
DRB: That's right.
WPIII: OK... and I can almost hear some folks out there saying, "That's great, D.R., but how can I move large amounts of wealth if so many options expire worthless?"
DRB: I'm glad you asked that.
Remember how - just a moment ago - I said that those daunting, high-percentages for options expiring worthless was just an "average?" Well, here's where that comes into effect.
WPIII: As well as the concept of "probability."
DRB: (Nodding and smiling) And the concept of probability.
Those terrible CME numbers were averages of options trades across ALL sectors, across ALL time frames, across ALL markets, and across ALL situations (backdrops).
As a trader, I don't operate in that manner.
In my book, The 10-Minute Millionaire, I explain how my trading strategy is designed to identify stocks (and therefore, the associated options) that are trading at an "extreme."
WPIII: And these "extremes" are created by human emotion - so we're talking about investor psychology.
DRB: That's right. Most investors and traders understand this. And most would love to cash in on the "other guy's" emotion-driven miscues.
But that can be tricky. In fact, this is what so often trips up investors or traders who want to capitalize on that emotion.
It's one thing to know that emotion (investor psychology) creates exploitable extremes. It's another to identify the "right" point to strike.
WPIII: Because when you talk about investor emotion - and things like the so-called "magazine cover indicator" - it can all become quite subjective, can't it?
DRB: Very much so.
That's why I developed my trading system, which quantifies those emotions - in essence, taking something as subjective as emotion and assigning it a mathematical equivalent.
WPIII: But a simple mathematical equivalent.
DRB: (Nodding) Something that's simple - and easy to understand... almost at a glance. A number.
You see, Bill, this takes the guesswork out of something that's otherwise very tricky. Those numbers serve as a kind of "radar" that lets me zero right in on stocks that are trading at "extreme" highs or "extreme" lows.
This means the stocks in question have been driven by investors up to their euphoric apex (highs) or beaten down to their doleful nadirs (lows).
WPIII: And that's very, very important ... and, in fact, is where increased probability comes into the picture.
DRB: Yes!
You see, when a stock has been driven to an extreme, the odds are very good that its next move will be in the opposite direction. I don't necessarily mean the next move a second later... nothing that granular. I'm talking about the next trend... be it an intermediate-duration move or even a longer-term one.
Take a stock that's been driven to a euphoric high.
The fact that it's at "an extreme," by definition, means it's not going to continue in that same direction. It's going to reverse course and go down.
Conversely, a stock that's been beaten to an "extreme low" is poised for a reversal.
In both instances, the probability is high that the stock will change direction. And if you understand that, you can make money. You can make money with the stock itself. Or you can "leverage" that opportunity and make an even bigger return by trading the option.
WPIII: And to profit, you want to sell (go short on) stocks that are trading at extreme highs since they are poised to reverse course and fall. And you want to buy (go long on) stocks that have achieved an extreme low since they are poised to reverse course and climb.
DRB: In a nutshell, Bill, that's really it. Trading the stocks can be very profitable. But using options allows you to leverage those opportunities and make even more money because you're risking small amounts of capital for very big gains.
WPIII: And illustrate this, you actually have an example - a recent example, in fact - and a trade that you actually did.
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DRB: That's right. And my very recent example is Best Buy Co. Inc. (NYSE: BBY).
This company is the last of the "big box" electronics retailers and a company that's been operating pretty well. It just reported a great quarter - with earnings above expectations and a big jump in revenue and same-store sales growth that was well above its competitors.
But there was a fly in the ointment.
In its "forward guidance," management said profit margins could get squeezed in the year's second half. And that one negative - even surrounded by the bevy of positives I mentioned - was enough for the stock to get slammed. Traders got crazy and beat down the shares of a company that executed really well on almost every metric. And that emotional reaction pushed the stock to an extreme.
Here's the chart I sent to my subscribers:
We jumped in after the selling stopped (what I call a "Hooke Pattern") - and up the stock went.
Here, now, where you see the true power of trading options... of "leveraging opportunities."
Just look at the chart I'm posting here.
Best Buy was pushed to an "extreme." My system allowed me to "see" that.
And the stock reacted to the "guidance slam" just as I predicted: It rebounded.
In fact, it rebounded 9% - not bad for such a short time span.
But the real action was in the options.
A properly chosen option exploded upward - zooming 200% in that same time span.
WPIII: (Laughing) Sorry... wow... that's a stunner. And that's what you mean by using options to "leverage opportunities."
DRB: That's exactly what I mean by "leveraging opportunities."
WPIII: That's the essence of your system... using mathematical probabilities to ID stocks trading at extreme highs or extreme lows - even if those extremes are intermediate ones - and using options to grab "leveraged" windfalls when they reverse course.
And that's why the options trades that you do aren't going to track the horrendous overall options record depicted in the CME study.
DRB: That's it... in fact, my experience and that of my subscribers shows it's the exact opposite of what those numbers seem to say about the futility of options trading...
WPIII: So myth busted.
DRB: Busted.
But let's be honest - no system is infallible... no system is perfect.
Even with a system as good as the one we've designed... the fact is that we're going to ID promising stocks that don't reverse course - or that do reverse course, but then don't follow through as quickly or as powerfully as expected.
That's OK.
Here's where the risk management component of my options strategy factors in.
WPIII: How so?
DRB: My management of risk starts before we initiate the trade.
And it has several features.
First, to protect us in case we're wrong and the trade goes against us, we pre-establish an "acceptable amount" of loss per trade...
WPIII: Kind of a "loss threshold?"
DRB: Right. And if the loss goes over that threshold, it automatically triggers a "sell"... and the trade is closed out. Experienced traders know this as a "stop loss."
WPIII: And that's true of stocks and options.
DRB: It works with both - and equally well.
WPIII: And your risk management strategy goes even deeper than that, doesn't it?
DRB: It does, Bill. It even tells us how much to risk on each trade so that we're not overinvesting or underinvesting. That, too, is mathematically guided... making it simple to calculate.
WPIII: And your risk management strategy also reaches out to include the "profit" side of your trades, correct?
DRB: Absolutely. Just as some traders hang with a losing trade so long, some traders can hang with a winning trade too long. In cases where you have a profit on an "open" trade, you want to be sure that you "keep" what you've made. My risk management tools set up a "sliding stop" that lets you stay in a trade as it's rising - but gets you out if it starts backsliding.
WPIII: The takeaway, here, is that - under your system - options are an instrument you'll want to trade... and that you're likely to profit on... and profit handsomely on. In fact, because you're putting probability firmly on your side and are "leveraging opportunities," it's to your decided advantage to trade options.
DRB: No matter what the pundits - and those CME statistics - would have you believe.
D.R.'s Sharing the Results of Another Radical Experiment
Over the past two-and-a-half years, regular folks – from all walks of life – were given simple instructions to look for a distinctive pattern in the markets.
For many of the participants, the results were mind-blowing: The first week, one man started with $5,000; he doubled it. One person raked in $4,598 in two days, while yet another pocketed $15,000.
Today, D.R. is sharing the results of this experiment with everyone…
The post I'm Busting One of the Biggest Investing Myths of All Time appeared first on 10-Minute Millionaire.
About the Author
D.R. Barton, Jr., Technical Trading Specialist for Money Map Press, is a world-renowned authority on technical trading with 25 years of experience. He spent the first part of his career as a chemical engineer with DuPont. During this time, he researched and developed the trading secrets that led to his first successful research service. Thanks to the wealth he was able to create for himself and his followers, D.R. retired early to pursue his passion for investing and showing fellow investors how to build toward financial freedom.