FOOL ON THE HILL
Why We Avoid Options

After two consecutive years of losses in the stock market, we are starting to hear about the benefits and relative safety of buying or selling options. Don't believe it: options are a zero-sum game. Just like casinos have a built in take on gambling in their shops, the only guaranteed winners in the options game are the brokers who collect the commissions.

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By Bill Mann (TMF Otter)
January 4, 2002

It generally does not pay to be doctrinaire in investing. Warren Buffett only became a superstar investor, a six-sigma event, after he became influenced by Charlie Munger, who taught him that it was OK to pay up for quality. Without Munger's influence, Berkshire Hathaway (NYSE: BRK.A) would have never bought See's Candies, for instance, nor would it have likely bought Coca-Cola (NYSE: KO). Both of these investments have paid for themselves many times over and their returns have been parleyed into several more investments.

I believe that there are many ways for investors to get to the promised land of superior investment returns. If you are proficient reading charts, go that way. If you find that you are an economic prognosticator extraordinaire, use that as your basis for investing. If you are willing to be honest about your abilities, I imagine there is someone out there who is succeeding spectacularly using nearly every seemingly crackpot strategy in existence. You can use any method you want -- daytrade to your heart's content -- but you must be able to consistently review your methods and results to make sure that you have what it takes to succeed. Most people, as it turns out, do not. As such The Motley Fool's mission is to show people what strategies offer the best chance of long-term success -- the only length of time that really matters.

This is why we suggest you ignore IPOs, that you avoid most mutual funds, that you forget about momentum trading, ignore charts, seek to buy companies for the long term, and just try focusing on what's under the hood of a business, and whether the current price offers you a reasonable chance of long-term appreciation. We do this because it is too simple to get caught up in the trends and hot theories of investing. The current one is that computer technology has changed everything. The last one was that "valuation does not matter, we're in a New Economy." At some point in the past it was "stocks are dangerous."

As always, there is an element of truth in the trend, which is what makes it both attractive and hazardous. Hazardous, because it is almost impossible to tell if something is real or not until much later on. How does the "new economy" feel right now? And right now, the thought is that strategies that offer "portfolio insurance" such as stop-losses and option hedges are not only prudent, but the way of the future.

Let's examine why I believe individual investors are little more than the fodder for the options market. First of all, unlike equities, there is no wealth creation at all in options. As such, in any options trade, one of the two participants MUST be wrong. In investing it is not necessarily the case. Because investments in equities are essentially entitlements to future earnings from a company, it is possible for both the buyer and the seller to be correct in a trade. If I sell my Intel (Nasdaq: INTC) because I believe it will go up less than 10% per year, but someone else buys it because he thinks it is safe and it goes up 8%, we are both correct.

Not so in options. There is a fixed amount of value in options, and each one eventually expires. Actually, in options it is possible for both participants to lose, because neither may gain enough to cover broker commissions. Look at it this way: If there is a town where the only economic activity is for people to buy umbrellas from one another, eventually the whole town will in fact be broke. There is no way for options writing to generate value. Actually, it's a highly valuable line of business for the brokers -- they get to keep the vigorish on the options, leaving the options traders worse off collectively by several billion per year.

This flies in the face of the whole reason that people buy or sell options. People "write" options against individual stocks. The theory is that if the buyer does not exercise the option, then the seller gets to keep the dividend and the purchase premium. If the option is exercised (meaning that the buyer chooses to either "Call" away the stock from the seller or "put" the shares to the seller), the theory is that the seller still comes out ahead from a combination of the dividend and premium.

Once again, under this structure, one of the two principals MUST be wrong. There are even complex mathematical formulas showing how such a program gives an option seller a decided advantage over equity holders. The best, most clear-headed study on options that I have come across is a 1988 out-of-print manual by Gary Gastineau called The Stock Options Manual. (I found it at Half.com for a few bucks). Gastineau is particularly pointed in his dismissal of options trading as an inherently superior strategy, and remarks that any backtested model should be treated with skepticism.

Since there are no value-creating events in options writing, you are necessarily left to compete against everyone else in the field. This is the main reason why we believe individual investors need to steer clear of options: You are really, truly investing with and against the big boys in a market. A successful long-term options strategy is going to likely require either some sort of shamanism, or an ability or technology that can spot pricing inefficiencies faster than the other players in the market. Again, if you believe you've got the first and you're willing to be honest with yourself in observing your results, be my guest. The latter is much harder to claim, seeing as there are thousands of pros with the latest and greatest computers looking for the exact same thing.

Yes, there are people out there with good long-term records in options, and yes, I am certain that there are some people who have figured out how to do it. I would not dream of telling a professional blackjack player that casino games are designed so that he can't win. Obviously, he has, or else he would be something other than a professional blackjack player. However, I would recommend that individual investors think very, very carefully before stepping into the options market. It is one that has a fixed amount of value, an immense deal of efficiency, and a guaranteed net aggregate loss for all participants.

So what is making option buying and selling more attractive right now? I believe it has to do with the human tendency to place more weight on recent experiences than more distant ones. The stock market has dropped like a stone for two years, and as such people are looking for some forms of insurance. One way is to match up options (for example, a put option) with a given stock position so that the amount of loss is capped in case the company drops like a stone. I can see how someone who is nearing retirement would want to do this: big losses could, at that point, be catastrophic. But the process of buying the put also decreases the potential gains on the stock, in present, not future dollars. Naturally, I see why this would be attractive, but it seems like an awful distraction from simply hunkering down and making a determination as to whether the company represents a bargain at current prices or is fully valued. And why is it that you are holding assets in stocks that you might soon need anyway?

That's the thing about options for most retail investors: It just makes something that is already so bloody complicated that much more so. We are already charged with the difficulty of determining what companies are good -- now we are trying to determine what the short- to medium-term price action will be as well, and to do so in a zero-sum game with a large and well-equipped group of professionals? Man, there is just no need. If you like a company and think the price is good, buy it. If the company seems expensive to you, sell it. Leave the casino games to the professionals, where game theory holds that in a field of players of equal ability, capital will eventually flow to the best capitalized. That, I dare say, is not you.

Our goal here is to try to keep investing simple enough so that it is understandable, but not to over-simplify. Options are a complex sideshow to investing in which the expected total return on invested capital is negative. Go there if you want to, but there is nothing inherently superior in strategies using options, and there is no options strategy that will provide a risk-free return.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill's random thought of the day: When a British publication quotes an American, why don't they use the American spelling of the word "favorite"? Do Americans actually SAY "favourite"? Bill owns shares in Berkshire Hathaway. The Motley Fool is investors writing for investors.