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.
|Yum! Brands (NYSE: YUM )
|Estee Lauder (NYSE: EL )
|Precision Castparts (NYSE: PCP )
|Southwestern Energy (NYSE: SWN )
|Novo Nordisk (NYSE: NVO )
|Potash Corp. (NYSE: POT )
|Chemical Mining Co. of Chile (NYSE: SQM )
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."
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.