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 (ETFC), TD AMERITRADE (AMTD), and Charles Schwab (SCHW 0.67%) 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's 2009 purchase of thinkorswim and Schwab'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.
But high-risk strategies aren't the only way to use options. Often, you can use options to reduce the risk in your portfolio or to take on risks that you're already comfortable with. For instance, if you want to hold on to a stock you own until it reaches a certain price but then plan to sell it, then writing a covered call allows you to receive a premium that you wouldn't get from simply setting a limit sell order. Similarly, if you know you want to buy a stock if it drops to a certain price, then writing put options can similarly pay you a premium and result in your getting that stock at the price you choose -- again, a better result than simply setting a lowball limit buy order.
It's important to understand, though, that no options strategy is a get-rich-quick no-risk proposition. Even with writing puts and calls, the risk is that you commit yourself to buy or sell shares at a certain price. For instance, if you write a put and the stock falls even further than you'd expected, then you're giving up the chance of potentially buying those shares even more cheaply. Similarly, with covered calls, the premium you receive compensates you for the fact that you're giving up any potential profit above the exercise price of the option.
Should you use options?
In the end, options are another investing tool that can be useful to control risk in some situations. Plenty of investors have become wealthy without ever touching the options market, while others get a lot of value from the sophisticated strategies that options can offer. The key, though, is that if you decide to use options, be sure you know what you're doing and understand the pitfalls that can result from common mistakes. Otherwise, you'll find yourself in a high-stakes poker game where the odds are decidedly against you.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.
