Skip to main contentSkip to navigationSkip to navigation
Leonardo Dicaprio in The Wolf Of Wall Street
Go on, buy options. Don’t you trust me? Photograph: Universal/Red Granite Pictures Photograph: Universal/Red Granite Pictures
Go on, buy options. Don’t you trust me? Photograph: Universal/Red Granite Pictures Photograph: Universal/Red Granite Pictures

The Wall Street product that could corrupt your investing soul

This article is more than 10 years old

Wall Street wants you to buy options, which are like derivatives with training wheels – and dangerous when mishandled

Let’s be frank: there’s no such thing as an investment product that is absolutely safe. Not, that is, if you want to actually make money on your investment.

There are products that add too much risk to our portfolios, even though they’re being offered to regular investors with no special expertise.

The same way the military refers to those outside its ranks as “civilians” and priests call anyone outside the religious order the “laity”, Wall Street also has its name for the kids not in its club: “retail”. If you’re not a financial institution, and you have less than $1m in investable assets, you’re a retail investor.

And if you’re a retail investor, there are some products you should never even think about.

A big one is the category of products that can be lumped together under the label of derivatives, aka what Warren Buffett called “weapons of mass financial destruction”. How you can identify them: most of them are unpronounceable. They range from straightforward options on the S&P 500 index to highly complex structured notes, such as – to pick one example at random – the constant proportion debt obligation or CPDO.

Let’s be clear: it’s easy to avoid temptation here. No broker or financial is going to let you anywhere near a CPDO, or a credit default swap, or any of the myriad other complex institutional products.

No such luck on another advanced product that is trickling down into the retail world: options.

Options are alluring. As their name suggests, they give you the option to buy -- or sell -- a stock, bond or any other asset ... in the future.

Here’s how they work: The option comes with a contract that lets you decide what fixed price you would like to pay, and which date. You don’t have to buy the stock or the bond; you just have the choice. They’re a good tool for speculation if, say, you are convinced that Johnson &Johnson stock is going to boom in the summer, or that IBM stock is going to fall. Options give you a way to minimize your losses in a market that is in freefall, or to enable you to pick up shares in a company at a predetermined price.

The terminology is easy to pick up. If you want to sell a stock in the future, you can buy a “put” option; if you want to buy a stock in the future, you pick a “call” option. The person you’re selling to – or buying from - is known as the “counterparty”. If you decide to go through with the trade you bought the option for, it’s called “exercising” it.

Maybe because options are not so complicated, the options industry has been urging us to consider “the responsible use of options” for years. And it seems to be paying off for them. According to a recent study, nearly a quarter of all options trading activity is coming from the masses of retail investors, rather than the professional traders for whose use they were first created.

Here’s the thing: while many of us certainly can learn how to use options effectively, most of us don’t really need to – or shouldn’t.

Let’s take a real-world example. If you’re worried that the S&P 500 is going to plunge 20% in the next few months, here’s how you use an option to make that bet: you can buy a “put” option to sell the S&P 500 any time over the next three months to someone else at a price below today’s. In exchange for that insurance, you fork over a premium to the person who’s buying the option. His name on Wall Street is the “counterparty”.

So let’s look at what happens to your option. If, by early June, the S&P 500 index trades where it is today, or it has gone up in value, your option is worthless and simply expires. You’ve lost the premium you paid, but at least you’ve had some peace of mind because you avoided a bad investment.

If the stock market does slump, you can make money by selling your option for a profit or you can exercise your option. When you exercise an option, you limit your stock market losses. That’s the anatomy of a bare-bones options trade.

So what’s wrong with that? Options sound like a great way to speculate - or, if you’re a professional trader, to hedge your risks. Either way, options give you flexibility, which is great.

But they also risk turning you into a short-term thinker, which, when we’re talking about investing, isn’t so great.

Because most options are short-term in nature, expiring in anything from a few days to a few months, if you’re using options you need to be scouring the markets daily and monitoring your positions. It gives you a short attention span for investing. And that kind of short-term thinking is one of the factors that no less an authority than Warren Buffett suggests you should avoid..

If you’re going to play in the options sandbox, you need to have a mind that’s good at thinking through scenarios and handicapping various probabilities of what could happen to a company’s stock, a bond, or even the entire S&P 500. Alternatively, you need a financial advisor who is both able and willing to take on that task.

Yes, it would be wonderful to use options and be able to feel immune from giant market selloffs like that of 2008 – or at least to limit our losses. But gargantuan market meltdowns like that come along once in a generation.

For most of us, the better response to any small dips in the market is to buy stocks of companies that look solid over the long term, and look cheap – meaning that the long-term value looks like it could be higher than it is.

It’s particularly essential to be careful because options aren’t free. The costs add up. The premium you pay will be small, with its price determined by the time left before it expires and the volatility of index or stock price in question. The more likely a scenario seems to the market, the more expensive protecting your portfolio becomes, however. And if it’s unlikely, the more likely you are to lose the money you invest in those options.

For most of us, it’s probably better to take the money we’d otherwise use to buy options and invest in some other kind of asset – perhaps something that we’d expect to do well when the market falls.

Options aren’t rocket science, of course. If you are interested enough to spend time and energy on learning how to use them, and can devote time to monitoring your portfolio (and avoid falling into the trap of short-term trading rather than long-term investing), then by all means, sign up for seminars on how to use them wisely.

But it’s never a good idea to assume that because you can invest in a sophisticated product, that it’s something you should be doing. That way madness lies.

Comments (…)

Sign in or create your Guardian account to join the discussion

Most viewed

Most viewed