A couple of weeks ago, while my wife and I were watching a Red Sox game on TV, I came across one of those ads selling the next get-rich-quick scheme. The name of the game this time was options. Apparently the strategy was so simple a kid could do it, because they had kids describing how much money they had made from their "summer job" trading options.
Needless to say, I had a hard time believing that this was for real. If there were such a simple strategy to getting rich, it wouldn't be sold via an infomercial. Would you share such a strategy for anything under a few million? Me neither.
For the next five minutes, my wife was treated to me berating the people selling this product and the parents who had turned their 12-year-old kid into an options trader when he should have been spending his summer outside playing ball, reading books -- doing anything but staring at a screen trading options.
Options do have a place
My little tirade apparently made quite the impression on my wife; a few days ago, the subject of options came up again. My wife is not particularly interested in investing, but she does have an inquisitive mind and generally despises how much of the financial world is made unnecessarily difficult. But after coming across the options infomercial and a few other brief mentions of options in magazines and on CNBC, she's curious why someone would buy options in, say, Apple (NASDAQ:AAPL) or Urban Outfitters (NASDAQ:URBN), instead of the underlying shares.
At the Fool we've generally advised people to avoid options, and I still believe that's the best advice for almost all investors. Even for the exceptions to that rule, I believe options work best as a limited portion of their portfolios. My colleague Seth Jayson has written about circumstances where options can make sense, and I walked my wife through some of the scenarios that Seth outlined to help her understand the pluses and minuses.
A few very good questions
After a little discussion, two option scenarios immediately made sense to my wife: writing out-of-the-money covered-call options, and writing put options for stocks that one would like to own, but at a lower price. This revelation was immediately followed by three questions:
- People actually take the other side of those two trades?
- Why on earth would someone take on that kind of risk?
- How is trading options without owning or wanting to own the underlying shares for years different from gambling?
In case you hadn't noticed, my wife is a smart cookie. She's also right. As I've said, options only make sense as a very small portion of a long-term investor's portfolio, and only when investors are already looking to buy or sell the underlying shares in the company. Options are a short-term trading tool, and all of the pitfalls and risks that accompany short-term trading apply to them as well. They weren't designed to provide long-term results.
Just a few good ideas
The allure of options is understandable. Everybody wants to get rich quick, but if everyone could do it, no one would feel the need to read this article or this site. Personally, I've made all of my most painful investing mistakes by trying to get rich quick -- Global Crossing (NASDAQ:GLBC) anyone? That's why I'm a big believer in needing only a few good ideas over a lifetime to become very wealthy.
I'm still stuck on the 12-year-old kid trading options and the disservice his parents are doing him. Assuming his experience was as good as advertised in the commercial, I have little doubt that he was lucky. He'll likely need to learn an expensive lesson to see things differently. Worst of all, after learning that lesson, he might swear off all forms of investing. That could mean he'll miss the experience of watching a company like Wal-Mart (NYSE:WMT) go from being a Hidden Gem candidate to a market dominator, or the dazzling effects that the dividends from cereal maker Kellogg (NYSE:K) can have for an Income Investor.
Foolish final words
The best path for investors with years of investing ahead of them hasn't changed in centuries: Take long-term stakes in those few good ideas you get over the years, and regularly add -- dollar-cost average -- to those holdings. Better yet, get into a dividend reinvestment plan if you can. Reinvesting dividends really turbocharges returns over long periods of time, even through bear markets. Last of all, don't forget that our biggest advantage as individual investors is time. We don't need to report our numbers quarterly or even annually to the outside world. We can let our companies compound over time, which allows us to enjoy family, friends, and beautiful summer weather.
Nathan Parmelee owns has no financial interest (short, long, or options) in any companies mentioned. You can view his profile here. The Motley Fool has an ironclad disclosure policy.
