Why You Won't Make Millions With Options

You've seen the ads:

  • "How we turned $5,000 into $800,000 in just one year with options trading!"
  • "Book 70% profit in one hour!"
  • "Profits of 150%+, 400%+, 800%+!"

Along with countless others.

Perhaps they've enticed you. After all, if you're one of the many investors who lost money over the past few years, you might be desperate for some quick, easy gains.

But too many investors will end up putting more capital at risk than they realize and lose a lot of money in the process.

It starts off innocently
You'll begin with a conservative strategy, perhaps writing covered calls on a position that you've owned for a while and has appreciated nicely, and you're ready to sell if it gets a bit higher.

Here are a few companies that might make sense writing covered calls on right now, if you've owned them over the past five years, since they're all large-cap companies that have appreciated nicely over that time period. You might just be ready to sell at the right price.

Company

5-Year Return

P/E Ratio

Yum! Brands (NYSE: YUM  ) 110% 23
Estee Lauder (NYSE: EL  ) 153% 29
Precision Castparts (NYSE: PCP  ) 171% 22
Southwestern Energy (NYSE: SWN  ) 184% 25
Novo Nordisk (NYSE: NVO  ) 261% 24
Potash Corp. (NYSE: POT  ) 452% 22
Chemical Mining Co. of Chile (NYSE: SQM  ) 507% 37

Data from Capital IQ, a division of Standard & Poor's.

You're paid a nice premium, and the options expire without being exercised, so you pocket it all. Then you repeat the process again. After several months, your options are finally exercised, and the underlying stock is called away from you.

You're impressed -- you've made several thousand dollars from the premiums and eked out a few more percentage points in gains on the underlying stock.

Now you feel confident enough to try more strategies.

But this is where you'll start to stray. You'll feel invincible, you'll want the easy money, and you'll take more and more chances to get it.

What's happened psychologically
So what happened to that calm, cool, even-keeled investor who simply wanted to add a few percentage points to his or her returns?

A few factors set in -- greed, recency and confirmation biases, and overconfidence.

Your recent returns made you want more, hence the greed. Your recent successes brought you to believe that these trades are risk-free and simple -- and that made you overconfident. Your overconfidence will cause you to take more frequent and more risky bets -- ones that you might not fully understand the risks of. And by entering into options contracts that you don't fully understand, you stand to lose your shirt if the trade moves against you.

And that's why most investors will not make millions with options.

Even the academics back up this scenario. A professor from the Haas School of Business at the University of California wrote a paper in which he says that because of overconfidence, "people are likely to trade more than they should and earn a little less than they would if they hadn't traded too much."

Don't misunderstand
I'm not saying options are a bad strategy. In fact, I'm a big believer that options can add income, hedge out some risk, and make money for your portfolio.

But you have to be aware not only of the risks involved with the options themselves but also the risks that they'll psychologically pose over time.

If you're interested in more information on how to smartly use an options strategy, I invite you to check out a video seminar and options-trading guide, The Motley Fool "Options Insider" Playbook, that Motley Fool options experts Jeff Fischer and Jim Gillies just finished putting together.

For a limited time, both the video and the guide -- whose content many investors have shelled out nearly $1,000 to see -- are completely free. Simply drop your email address in the box below for more information.

Adam J. Wiederman owns no shares of the companies mentioned above. The Motley Fool owns shares of Yum! Brands. Motley Fool newsletter services have recommended buying shares of Precision Castparts and recommended writing puts in Southwestern Energy. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 17, 2011, at 6:44 PM, 123spot wrote:

    Needed to be said. And needed to be read, by me. Especially now. Thank you. Spot

  • Report this Comment On June 17, 2011, at 8:18 PM, FlyingRiki wrote:

    Why should I believe that if I can't pick consistant winners with normal investing I should trust myself to try with options.....Hellooooooooooooo!

  • Report this Comment On June 18, 2011, at 10:28 AM, Pandorabelle wrote:

    So true, and absolutely important to be ackowledged. But what about the people who have less than 5K to invest? What about the people with $500 or less to invest? I'd like to see the Fool offer some (options?) strategies to help these folks get enough capital to begin to accumulate actual shares. Unless you can offer some help for this level of investor, it appears the Foolish neglect a demographic that most needs their help.

    The discussion above is incomplete without Foolish attention to the market makers/funds/hedgies practice of manipulating share prices at options expiration---especially as the list of stocks w/weekly options grows. It's the dirty inside 'secret' that yanks share prices and subsequently options value--seemingly inexplicably--that no one wants to discuss. Will the Fool step up?

  • Report this Comment On October 01, 2012, at 7:00 PM, cudjoemon wrote:

    All BS I've made millions trading options. You just have to know what the hell you're doing. Oh BTW I started with 40K.

  • Report this Comment On December 02, 2012, at 11:07 PM, JimsonLee wrote:

    My best option win was Yahoo, bought some out of money call options short expiration, and sold on Microsoft buyout rumor, good thing my wife called me, I was sleeping, and only had a 2 hour window to sell, turned $400 into $8000. The day before, and the day after they went to zero, thought I was out the $400

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