Potential Pitfalls of Investing in Options

Rich Ellinger
Thu, 17 Jul 2014 00:00:00 +0000

Ameritrade, E*Trade and some of the other leading brokerage firms have started marketing option securities to private investors. They claim even small investors can boost their returns by adding options to their portfolio. However, a new study from SigFig and The New York Times shows investors that traded options received returns 80% lower than those that only invested in stocks, bonds and other securities. This statistic doesn’t mean options are inherently a bad investment. They can be excellent for hedging risk in your portfolio. However, buying and selling options for profit is much riskier. It is imperative you understand the risks before adding options to your portfolio. This article isn’t meant to discourage you from trading options. We just want to make sure you will be making an informed decision. Keep in mind you can sell options as well, but we will only discuss buying them today.

What Are Options?

Options are derivative securities that allow investors to buy or sell a stock at a given price. There are times this privilege can come in handy. There are two different types of options. Put options give investors the right (but not an obligation) to sell a specific stock at a given price (known as the strike price). A call option allows investors to purchase the same stock at the given strike price. There are times this can be a very lucrative privilege. For example, the price of a stock may increase to $110 a share. If you purchased a call option with a strike price of $90 then you could buy a stock at a $20 discount and immediately sell. There are two ways you can make a profit from trading options. You can either exercise the option to trade the underlying stock at a premium or discount, or you can hold the option and sell it, if it appreciates in value, before it expiration date.

Individual Investors Must Understand Risks of Option Trading

Options are complex financial derivatives. Many novice investors have a difficult time understanding them. This can create problems if they try to trade them in their portfolio. According to a study by Dr. Renaud Piccinini, a former risk analyst for Ameritrade, many Ameritrade customers were placing very risky trades. Piccinini felt Ameritrade should have warned its customers about the risks they were taking. Of course, it would always be great if brokerage houses took the time to provide investing advice, but the responsibility of making competent trades ultimately falls on the shoulders of the investor. You have no one to blame but yourself if you are making bad trades, so you need to learn what you are doing first.

What Are the Potential Pitfalls of Options?

Options have received a lot of bad press, largely because many investors trading them have experienced large losses. The truth is options are not necessarily bad investments. However, there are some risks associated with them that many investors aren't prepared for.

100% Loss If Stock Doesn't Get Above / Below The Strike Price

The major downside is an option is completely worthless if the investor can’t exercise it to make a profit. Suppose you purchased an IBM call option with a strike price of $90. Shortly after buying the option, the price of IBM’s stock drops from $100 to $85. It wouldn't make any sense to pay a $5 premium for a share of stock, so the option is useless. You would have experienced a 15% loss if you purchased the stock, but with an option you lost the entire initial investment. Goldman Sachs even warns investors about this risk on the disclaimer page on its website, because it happens very frequently. A study conducted by Dr. John Summa of Options Nerd found that about 82.6% of options expire worthless. You would face the same risk if you invested in a put option with a strike price of $90. You would lose your entire investment if the stock price stayed over $90 a share.

Value Erodes With Expiration Date

Every option has an expiration date. Otherwise, investors could hold onto them indefinitely until the stock traded above and below the desired strike price. This leaves investors a limited timeframe to exercise their right to buy or sell the stock at the strike price. The value of the option will drop steadily as the window of opportunity closes. This makes sense when you stop to think about it. If a put option doesn't expire for 90 days, then investors have plenty of time to wait for the share price to go below the strike price so they can exercise it for a profit. However, the option won’t be nearly as valuable if it is due to expire in a couple of days, because there is a much lower chance the stock will go below the strike price.

Higher Volatility

Options are much more volatile than stocks. You will need to find out what the delta of the option is to predict future volatility. This value is printed under the “Greeks” section of most sites providing option data. I found a recent example from NASDAQ which will help you understand the volatility of options. The current delta for a June 6, 2014 IBM call option with a strike price of $185 is 0.79. This means the value of the option is expected to increase $0.79 for every $1 increase in the share price. The price of the call option and a share of IBM stock are trading at $20 and $181 a share, respectively. Investors that purchased a share of IBM stock would experience a 10% gain if the price increased by $19 to $200 a share. However, the price of the call option would increase by approximately $15 ($19 * 0.79), which means investors would face a 75% gain in that time period. As you can see, there are opportunities to make a lot of money by trading options. You could wait 7 years for a share of stock to double in value, while an option’s value can double overnight. This is one of the reasons they can be so appealing. However, the higher volatility is a double-edged sword. Even a very small drop in the share price can cause a substantial loss.

Poor Market Timing

Most traders believe they can time the market, but very few people have been able do so consistently. Poor market timing is one of the biggest reasons investors experience high losses. A recent study from several economists in the Netherlands found that options traders trying to time the market lose three times more than stock investors. Short-term trading strategies are always riskier, because the market is more volatile in the short run. Options investors can’t wait for the market to correct itself, which means timing is always essential.

Investor Skittishness

Investors can also become irrational after witnessing large changes in value. They often rush to sell their securities after a significant price drop, rather than holding and waiting for the price to rebound. Options investors are even more likely to sell their options prematurely, because they know they will lose their entire investment if they hold an option that can’t be exercised before maturity.

Should You Trade Options?

Options can be great securities to diversify your portfolio. However, they are best used for hedging the risks of your investments. You can use a put option as an insurance policy to sell a stock at a reasonable price if the stock’s price drops significantly. Speculating in options is much riskier, because you have a very limited period of time to exercise them and they tend to be much more volatile. You will need to watch the market closely if you intend to profit.