Options sellers vs. buyers: Who wins?

By John F. Summa

Option traders rarely take into account a little known underlying fact about the
derivatives markets: Most options expire out of the money. A study analyzing three
years of data compiled by the Chicago Mercantile Exchange (CME) confirms it.

That means buyers lose on most options trades. Given this option market reality, serious
options traders should consider developing a net option selling (writing) approach to take
advantage of this tendency.

Three key patterns emerge from this study of CME data:

1. On average, three out of every four options held to expiration end up worthless.
2. The share of puts and calls that expire worthless is influenced by the primary
trend of the underlying market.
3. Option sellers still come out ahead even when the seller is going against the trend.

Based on a CME study of expiring and exercised options covering a period of three years
(1997, 1998, 1999), an average of 76.5% of all options held to expiration in five markets
expired worthless (out of the money). The number remained consistent for the three-year
period.

The actual numbers for five markets show more than 20 million expired (worthless)
options and a little more than 6 million exercised (in-the-money) options. Futures
options that are in the money at expiration are exercised automatically. Therefore, we
can derive total expired worthless options by subtracting those exercised from total
options held to expiration. A closer look at the data reveals certain patterns, such as how
a trend bias in the underlying affects the share of call options vs. put options expiring
worthless. Clearly, however, the overall pattern is that most options expired worthless.

Consistent Results
The table also presents totals for exercised (in-the-money) and expiring worthless options
for the five individual markets – S&P 500 index, Nasdaq 100 index, eurodollar, Japanese
yen, and live cattle. For both puts and calls traded in each of these markets, options
expiring worthless outnumbered those expiring in the money.

For example, a total of 2,739,573 S&P 500 put options expired worthless compared with
just 177,741 that expired in the money. As for S&P 500 call options, a primary bull
market trend helped buyers, who saw 587, 279 expire in the money compared with
843,414 call options expiring worthless, clearly this shows a much better performance by
call buyers than put buyers.

Presenting the data in percentages makes the comparisons a little easier. As a whole,
S&P 500 put options recorded the highest percentage with 82.6% expiring out of the
money or worthless. This percentage was above the average for the entire study - 76.5%
of all CME futures options expired worthless – and is due to the stock index options on
futures (Nasdaq 100 and S&P 500) having very large numbers of put options expiring
worthless – more than 90%.

The bias in favor of put sellers can be attributed to the strong bullish bias of the stock
indexes during this period, although there were some sharp but short-lived market
declines. Data for 2001-03, however, would no doubt show a shift toward more calls
expiring worthless, reflecting the change to a primary bear market trend since early 2000.

Nasdaq 100 Index

With a closer look at the individual markets, especially stock index futures options, it
becomes quite clear how the primary trend in the underlying futures market affects the
share of puts and calls expiring worthless. In spite of this pattern, both puts and calls
expiring worthless easily outnumber those expiring in the money. For example,
remarkably, 82.6% of all call options and 96.1% of all put options for the Nasdaq 100
expired worthless between 1997 and 1999.

The most bullish of the three years was 1999, as the Nasdaq 100 weekly chart illustrates.
The fourth quarter of 1999 witnessed the last, and most explosive, move higher by the
Nasdaq 100 to above 4,000. Put option buyers were throwing their money away during
1999, as 98.3% of all put options in that year expired out of the money.

Despite the bullish move in prices, call buyers still lost to sellers as 82.6% of all calls
expired worthless that year. Clearly, buyers are on the losing side of most trades, as only
3.9% of all put options expired in the money, and only 17.4% of all calls purchased were
exercised, as the table shows.

In absolute numbers, worthless Nasdaq 100 options dwarf the number of those exercised
in the money at expiration, with 111,490 puts and 65,928 calls expiring worthless
compared to just 15,541 calls and 5,660 puts expiring in the money. This is a ratio with
more than 19-to-1 for puts expiring worthless vs. those expiring in the money. For call
options, the ratio is approximately 4-to-1 expiring worthless vs. expiring in the money.

It should be noted, that these percentage might actually be understating the severity of
bias in favor of sellers. Even if an option expires in the money, it may not be a profitable
trade because the option needs to be in the money enough to cover the premium paid for
the option, at which point it becomes profitable. At the same time, because sellers
receive premium when they write an option, they do not necessarily lose on the trade just
because an option expires in the money.

If you sell a stock index put option for 20 points, it must expire by more than 20 points in
the money (that is, below the strike price of the put) for the trade to be a loser. Therefore,
the expiration data are actually understating the advantage writers have over buyers,
because the data only reveal the number of options expiring worthless, not by how much
in the money the options are expired. Clearly, some of the exercised, in-the-money
options that are counted as winners for the buyers in this study are actually losers.
S&P 500 Index
Turning to options on the S&P 500 index futures, the second most active options group
after eurodollars, the pattern is similar to that of options on Nasdaq 100 futures. During
the study period, a total of 2,739,573 put options and 843,414 call options expired
worthless. Just 177,741 puts options and 587,729 call options were exercised in the
money.

In percentage terms, 93.9% of all S&P 500 put options expired worthless while just
52.9% of all call options expired out of the money, again due to the primary bull market
trend evident on the chart that led many to buy puts as insurance, most of which expired
worthless. Just as with the Nasdaq 100, the highest percentage of expiring put options
occurred in 1999, although it was only slightly higher than in the previous two years.

Despite the sharp but brief declines in the S&P 500 in October 1997, September/October
1998 and October/November 1999, put sellers held the upper hand. Despite the
bullishness that followed these selloffs, call buyers still lost to sellers, posting their worst
performance in 1999 when 66.7% of all calls expired worthless, up from 56% the
previous year.

Eurodollars
The most active options market is eurodollars, where buyers fared a little better than in
options on stock index futures as 78.2% of all eurodollar put options and 74% of all call
options expired worthless. More than 4 million put options and 4 million call options
expired out of the money during the three years in the study.

Note that there was a sharp drop in both the percentage and number of put options
expiring worthless in 1999. The percentage of puts expiring worthless in 1998 amounted
to 91.8%, but this figure dropped to 58.4% in 1999, which can be attributed to the change
in the primary trend to bearish for the eurodollar market, as the chart indicates.

Meanwhile, there was a sharp increase in the percentage of calls expiring out of the
money, going from 65.2% in 1998 to 90.2% in 1999. As the market became bearish in
1999, the number of calls expiring in the money fell from 704,947 to 225,595. The
percentage of calls expiring in the money, therefore, dropped from 34.8% to just 9.8%.

Only 834,033 puts expired worthless that year, less than half as many as in 1998, again
reflecting the bearish trend of 1999. The other two years of the study period were bullish,
which is reflected in the higher share of puts expiring worthless relative to calls.

Japanese Yen
The Japanese yen suffered a major bear market throughout 1997 and the first half of 1998
before moving sharply higher, as the yen chart shows. In 1997, just 50% of the puts
expired worthless, but this number rose to 70% in 1998 as the bear market came to a
sudden end with a major rally in the yen. As the yen continued higher into late 1999, put
sellers continued to enjoy the benefits, as the percentage of puts expiring worthless rose
to 80.5%. Interestingly, however, call buyers still faced a tough market.

In 1997, 85.8% of all calls held to expiration ended up expiring worthless, but this
number remained high despite the turn in the market in 1998, when 80% of all calls
expired worthless. As the bull market continued, 72% ended up out of the money in
1999.

Live Cattle
Though not a financial market, the same patterns observed in the other futures options
markets appear in options on live cattle futures. During the study period, 76.7% of all
call options and 73.7% of all the puts ended up expiring out of the money.

In 1999, however, a whopping 90% of all put options expired worthless, and in 1998 91%
of all call options expired with no value for the buyer. Once again, the extremes can be
attributed to the direction of the underlying market, illustrated by the chart. During 1998,
the trend was strongly bearish; the following year it was the reverse.

Clearly, put and call sellers had a trading edge going with the trend. Yet, remarkably,
even going against the trend, sellers had approximately a 50% chance of winning on
expiration (that is, having the option expire out of the money). Despite the strong trends
apparent on the chart, buyers of call options had at best a 48% chance of winning in 1999
during the bullish period and put buyers had just a 55% chance of winning in a bearish
1998 – again, this assumes the options expired deep enough in the money to cover the
cost of the option.

A Seller’s Market
Although this three-year study is not the entire story, overall the data suggests that option
sellers have an advantage in the form of a bias toward options expiring out of the money
(worthless). If the option seller is trading with the trend of the underlying market, this
advantage increases substantially. Yet, if the seller is wrong about the trend, this does not
dramatically change the probability of success. The buyer, therefore, would appear to
face a decided disadvantage relative to sellers in options markets.

Even though the data may understate the case for selling because it does not tell how
many of the options that expired in the money were winning vs. losing trades, the data
should say enough to encourage you to think about developing selling strategies as your
primary approach to trading options. That said, however, be aware that selling strategies
can involve substantial risk, so it is important to practice strict money management and
trade with only risk capital when deploying selling strategies.

John Summa is president of Optionsnerd.com and co-author of the recently published book, Options on
Futures: New Trading Strategies, with Jonathan Lubow.

From the March 2003 issue of Futures Magazine.