Private investors routinely engage in a variety of financial behaviors that are ostensibly intended to enhance their wealth, but these behaviors often do them much more harm than any good. One of these primary means of self inflicted wealth destruction is in the listed options markets.
Options contracts trade on exchanges like the CBOE (Chicago Board Options Exchange) and others, where investors can buy or sell contracts that bet on stocks, indexes, commodities and other assets going up or down. Call options are a bet on the “underlying” asset going up, Put options are a bet on the asset going down. Options trading can be extremely complex and requires a high level of skill and experience to be used successfully. Professionals and some public traders routinely use a variety of sophisticated and sometimes convoluted strategies to hedge positions, enhance leverage, make bets and disperse risk, as they have the tools, experience and knowledge to use options correctly. Even with all those advantages, sometimes even the professionals can get crushed trading options.
There are some more conservative strategies in options trading such as the “buy-write” position, once referred to as “covered call writing”, where owners of stocks collect option premiums on their shares while they hold them. If the stock goes down, you keep the stock. If the stock goes up, you must sell the stock to the option owner, who buys it for less than the current market. Sounds great doesn’t it?
Unlike stocks, bonds, mutual funds ETFs and other investment products, options are in the form of contracts, something like commodity futures. An option contract means you have entered into a specific agreement to buy or sell a specific asset at a set price at a specified moment in time. In all contract type trading, there is someone on the other side of your contract; (or something such a computer running a high speed algorithm) that is probably much better than you at trading options.
The difference in an investor’s experience between buying an ordinary security like a stock or mutual fund and trading options contracts is like the difference between buying groceries at the supermarket and playing poker with Las Vegas professionals.
People like trading options because they require only a small cash commitment; players can engage in the great game of high finance for low money; a couple of grand can get you engaged in options trading.
Like the 25 cent slots in Vegas, small players are attracted by the promise of big upside for only a small investment. The difference between gaming and options trading is that casinos are overtly and transparently gambling establishments, while options trading appears to many small investors to be a sophisticated way to build wealth. At the casinos, at least they serve you cocktails.
There are structural problems for private investors in options trading. Since option contracts are priced in “premiums” like insurance, they are by their nature rather expensive. When buying contracts, public investors often pay more than 100 cents on the dollar of estimated contract value, and when selling they often receive less than 100 cents of the same estimated contract value. Professional market makers (often computers these days) on the other side of your trade usually get the difference.
One more recent trend among options purveyors is to sell the public on the idea of options as portfolio “protection”, buying contracts that gain if your stock portfolio loses; a classic hedge strategy. What they fail to mention is the accumulated and ongoing cost of that “protection”, which is usually quite expensive and constantly adds to the overall cost of your portfolio.
Finding statistics on how public investors actually do in options trading is not easy; as the CBOE and other interests would likely prefer this information is not widely distributed. A May 24th 2013 article in the NY Times summed it up:
Motivated by wishful thinking and an attraction to financial markets as a casino of sorts, public investors routinely lose their shirts trading options contracts. Some independent estimates of the failure rate for public options traders are in the 90% range.
As a matter of investment policy, I do not permit our clients at Kensington A.M.I. to trade options. “Addition by subtraction” as we like to say around here.