The promise of getting rich quick never goes out of style. Whether it’s the latest side-business scheme or the perfect penny-stock pitch, many people are vulnerable to questionable and risky strategies that hold even the possibility of producing great wealth.
Unfortunately, even legitimate and useful tools to help people with their investing are prone to misuse, and recently, options trading has gotten a lot more attention, becoming a focal point for ordinary investors and the discount brokers that serve them. Let’s take a look at why trading options is somewhat controversial and why you shouldn’t just dismiss options out of hand.
The search for more business
An recent article in the New York Times highlighted a trend among brokerage companies, observing that some major brokers are talking about the benefits of options on stocks, ETFs, and indexes. The article called out E TRADE Financial Corporation (NASDAQ:ETFC), TD Ameritrade Holding Corp. (NYSE:AMTD), and Charles Schwab Corp (NYSE:SCHW) as advertising the rewards of options trading, noting that trading in options and other derivatives like futures contracts have made up an increasing part of brokerage firms’ businesses. Indeed, those companies have deliberately sought to increase their exposure to options, with TD Ameritrade Holding Corp. (NYSE:AMTD)’s 2009 purchase of thinkorswim and Charles Schwab Corp (NYSE:SCHW)’s 2011 buyout of optionsXpress having greatly enhanced their ability to serve sophisticated investors.
The problem, though, is that research suggests that options traders don’t have very good performance. One issue is that by their nature, options are generally short-term instruments, distracting investors from long-term trends and instead forcing them to assess probabilities of share-price movements over very short periods of time. Yet arguably, the bigger danger with options is using the extensive leverage they offer to take on too much risk.
Options are what you make of them
Admittedly, options can produce amazing short-term profits if you use high-risk strategies and have perfect timing. Whenever a stock rises or falls sharply, options investors can see dramatic changes in the value of the options they own, with gains of 1,000% or more not being unusual for options that are close to expiration. The psychological impact of those payouts when they come can tempt traders into always using high-risk strategies.
Unfortunately, such strategies also produce 100% losses on a fairly regular basis when investors don’t have perfect timing in making the right call about a stock’s direction. That’s a big part of the reason that options traders routinely lose money: They ignore the very real risk of losing everything by not controlling the amount they risk on a particular position.