Why So Many Investors Lose With Options

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 (NASDAQ: ETFC  ) , TD AMERITRADE (NYSE: AMTD  ) , and Charles Schwab (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'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.

Many investors use options to generate income, but if that's what you're looking for, you might prefer simply buying stocks that pay healthy amounts of income to shareholders. The Motley Fool has compiled a special free report outlining our nine top dependable dividend-paying stocks. It's called "Secure Your Future With 9 Rock-Solid Dividend Stocks." You can access your copy today at no cost! Just click here.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.


Read/Post Comments (7) | Recommend This Article (5)

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  • Report this Comment On July 10, 2013, at 11:42 AM, cpham2005 wrote:

    in addition to items mentioned in the article, even when option investors were right in timing and the direction of stock movement, option investors are still losing money for the following reasons:

    1. bid/ask spread is greater than 15%

    2. high buy/sell commissions and fees

    3. fast decay in premium when stock has high volatility, which market is doing now..

    4. Market makers pinned stock prices at the expiration to inflict the max pain to option investors

    5. small option investors can not sell option,unless they have to sell and buy spread which cost more in commissions+fees+wider bid/ask prices ( 4 ways instead of 2 ways)

    6. zero tax benefit for losers, but higher tax rates for a few winning bets.

    option is a rigged game, it was designed as a hedging tools, but over time WS turned into sucker bets for unaware, greedy investors. In the long run, the house is always win and players always lose.

  • Report this Comment On July 10, 2013, at 7:31 PM, hbofbyu wrote:

    Great info. Thanks

  • Report this Comment On July 11, 2013, at 3:47 PM, jwagner95 wrote:

    For every option trade that loses money, the other side made some. Educate yourself, be patient and wise and you will find yourself on the winning side of options more often than not.

  • Report this Comment On July 12, 2013, at 3:25 AM, ChaSuccess wrote:

    Fortunately for me, I have an excellent mentor who teaches me the real deal about what moves the markets. Since I have been actively trading options for a month and a half (after 5 months of study and demo acct), my account is up 59.99% for the month and yesterday my account was up 12.43% for the day. I started with a small capital. And one thing I noticed about this article is that they mentioned 3 brokerages who all have their Earnings Report on the 15th... I wonder if the editor of this article did a PUT option before releasing this article for some quick profits before Monday :) Our wealth institute play the players not the game ;) No sheeple over here!

  • Report this Comment On July 13, 2013, at 8:19 AM, daveandrae wrote:

    ^

    You do realize that the key phrase in your post was "a month and a half"...which is basically a joke to those of us that have been around the block.

    Having been investing in this business for over 15 long years, I can tell you from personal experience that you're playing a game of russian roulette with four bullets in a six shooter.

    Sooner or later the market IS going to blow your head off. Especially when, not if, you're up big and bet it all.

  • Report this Comment On July 13, 2013, at 3:59 PM, FoolTheRest wrote:

    Awesome, Cha! So if you started with just $1,000 and you earn 12.49% daily, you will be the world's richest person in just 147 trading days! Of course, it may take a little longer, since you cannot do that every day. But if you keep earning 60% per month, you will break into the Forbes 400 in two years. I am pretty sure that is how everyone else on that list got there. I cannot illustrate better than daveandrae already has how this is going to turn out for you.

  • Report this Comment On July 28, 2013, at 9:55 PM, Zardoz0609 wrote:

    I have been trading options for years. It takes time and a good deal of education to maintain consistent returns. The thing that 99% of traders don't always fully grasp is that trading is a loser's game. In other words, you can't predict the future and 9 out of 10 times, you will probably lose. That 1 out of 10 times that you win, should make up for the other 9 losses. The successful traders will tell you the most important aspect of trading is risk management and having a solid exit strategy that you follow to the letter. Options provide traders with a set risk amount and a clearly defined exit point.

    Trading is a loser's game. Don't forget that.

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