Popular Misconceptions About Options

Newcomers to the options world are usually eager to learn all about options, but arrive on the scene hindered by misconceptions gathered in chat rooms or online forums.  It's difficult for novices to ignore what they believe they have already learned.

This post represents an effort to eliminate some of those misconceptions – and prevent you from making a newbie error.  As you read the writings of the excellent group of bloggers who are participating in the options section of Minyanville, I believe you will gain confidence that we are providing good, accurate and useful information.  Our purpose is to help you travel safely through the options universe.

Some of the terminology that follows may be unfamiliar to you.  In this case, that's a good thing.  It means you don't have any of those misconceptions.

Misconceptions clarified.

1)  Exercise. 

a) The owner of an option – either a call or put – has the right to exercise that option.  When you own of an option, you will seldom, if ever, want to exercise.  But you have the right to do so.  When you no longer want to own an option, sell it. 

b) The option seller has no rights.That means you cannot request or demand that the owner exercise the option.  You can do nothing but wait.

c) If an option is out of the money by one or two cents when the market closes on the 3rd Friday of the month, there is still a (very) small chance that the owner of the option will exercise.  Some believe there is zero chance the option owner will exercise.

d) If an option is in the money by one or two cents when the market closes on the 3rd Friday of the month, there is still a (very) small chance that the owner of the option will choose not to exercise.  Some believe this is not possible.

e) If you are assigned an exercise notice ('assigned' for short), your broker will let you know before the market opens for trading.  Here's something else that confuses many rookies:  most of the time, there is nothing to fear when you are assigned an exercise notice.  In fact sometimes it's exactly what you want to happen.

f) If you buy an option sold earlier, then you are 'off the hook.'  If the option owner exercises the option, it has no affect on you.

2)  Pinning. 

Some people believe that option traders with large positions can 'force' specific stocks to close at, or very near, the strike price on expiration Friday.  It's not true. 

What is true is that it's possible for a stock to move closer to a strike price as buyers and sellers with opposing option positions (one group owns calls and the other owns puts)  make normal trades to reduce their expiration risk.  But the ability to drive a stock to a strike price does not exist.

3)  Stock movement and option prices

True or False:

a) Calls always increase in value when the stock moves higher.

b) Puts always increase in price when the stock moves lower.

c) Buying puts AND calls guarantees you make money if the stock price changes

False, False, False.

Calls usually gain value when the stock moves higher, but it's important to understand when an exception is likely.  We'll discuss this topic in detail.

I trust any misconceptions on these topics have been clarified.


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