Is Option Trading for You?

There is a recent advertisement running on the financial news networks about options. Each segment starts with a Fact and is followed by language that encourages the viewer to buy some option software so that you, the investor, can trade options and become a profitable option trader. Not only are some of the facts misleading, there are a lot of facts simply missing. I was surprised by the lack of warnings that typically accompany any advertising or marketing that encourages folks to trade options. Options, because of their extreme high risk, have always been one of the more highly regulated investment products.

Since their entry into the markets in the early 70s, the regulators have always considered options as high risk investments. In some forms, they can even be more risky than commodities. If you are interested in trading options, I encourage you to get a hold of the numerous pamphlets and books written on the subject. The following are some of the basics. An option is, in its simplest terms and as the word so describes, an option to do something or have something done to you. Options consist of puts and calls, and you can either buy or sell each of them. You can trade them if you are bullish or bearish, and with or without owning the underlying security. In which manner you decide to trade options will determine just how risky a position you end up taking.

Commissions/Costs

Those who are familiar with my articles know that my slant is to inform the reader of the risks and conflicts that abound in the securities markets. Options fall right into that group. Stockbrokers love clients who trade options, because they are so commission intensive. Options are relatively short-term investments, because they have a time limit within which they expire. So if you buy or sell an option, you will be closing out your position usually within a matter of weeks or months (as opposed to a stock or mutual fund that you might buy and hold for a couple of years). This causes your account to turn over more often which means that on each transaction your broker collects a commission. Also, on a percentage basis, the commissions tend to be much higher on options versus on stock. With people now commonly trading stocks at 10 cents a share, youll find that the commissions on options are a much more profitable venture for your broker. This applies even if you have an online trading account and not a broker per se.

Additionally, any time you are making a lot of short-term option trades, you also have the cost of the spread between the bid and the ask on any security. Option trading subjects you to the constant dilemma of having to overcome these spreads to make money.

Covered Calls

The term conservative, in my view, does not properly describe any kind of option transaction. Though there are those who espouse that a covered call writing program is conservative, it is not. Lets see how by looking at the following covered call. If you own 100 shares of Amazon.com and you sell a call on that 100 shares, the person who buys the call from you pays you a certain amount of money, called a premium, to purchase Amazon.com from you at a set price. Those who pontificate on the conservative nature of covered calls do so by saying that if Amazon.com goes up, the stock is called away from you at a higher price and additionally, you get to keep the premium. What a wonderful transaction! You made money on a relatively short-term basis. What is misleading about this is that as a result of this transaction, you bought Amazon.com, and Amazon.com can go down. Sure, you collected a small premium by selling the call, but Amazon.com can go down a whole lot more than the small premium you collected. You have only reduced your risk in owning the underlying security by only the amount of premium you obtained for the option.

On its face, covered call writing is one of the most stupid investment strategies there is. Why? Because when you do a covered call, youve made an investment with a very limited upside and a totally unlimited risk on the downside. Doesnt that sound stupid to you? Brokers and brokerage firms love it, because not only can it create a lot of option trading, but if the stock is called away, your broker has reaped another commission.

Buying Puts and Calls

Another argument you will hear from the profiteers of options is that if you want to control the risk of options, only be a buyer of puts and calls The theory is that if you only buy puts and calls, you can only lose the amount of money you pay for them. No argument there. The problem is that your chances of making money are extremely slim. If you buy a call (bullish) or if you buy a put (bearish) on, you are making a bet that the stock will move in a certain direction. But the big difference is that for you to make money, you not only have to guess right on which way the stock is going to move, you now you have a time limit within which it has to happen. If one or the other doesnt happen, the option expires, causing you to lose all of your money. The other uphill battle is that on the buy side, you have paid money, a premium, to buy this option. So not only does the stock need to move to a price at which you placed your bet, but the stock has to move through that price to overcome the premium that you paid for the option. The only exception is if the stock moves in your favor right after you buy the option, in which circumstance you can unload the option quickly for a profit. But just remember the general rule that 80% of all options expire worthless.

Uncovered or Naked Options

Brokers, being salesmen, never miss an opportunity to make a sale. So, your broker may try to get you to enter into a trading strategy called selling naked options. A naked option is when you sell an option but you dont own the underlying security. This is one of the riskiest transactions you can make in the investment markets. Lets say that Amazon.com has been trading between $100 and $200 all year, and you feel that there is no way that it is going to trade below $100/share. You go out and sell 10 Amazon October 100 puts for $5/each. Each option is for 100 shares, so by selling 10 you have sold the right for somebody to make you buy (put) 1,000 shares at $100 between now and October. For this, you collect $5,000. But if you are wrong and Amazon goes below $100 before October, you may be forced to buy 1,000 shares at $100. Thats $100,000 to you. Sure, you got $5,000 so you can say your real cost is only $95,000 but what if the stock goes to $70? Your total upside in this transaction was $5,000. And at $70, you are staring at a $25,000 loss.

You can conduct the same strategy but at the opposite end where you would be selling calls and betting that the stock does not go up over a certain price. You can be lulled into comfort with this strategy for months on end, thinking its like taking candy from a baby. It is only because you are guessing right and the market is going in your direction. But when the market turns (and it will), it can wipe out your entire life savings. In todays volatile stocks and stock market, you are probably better off to go to Vegas than trade options.

Contact Ms. Stoneman - Stoneman Law Offices - Texas & Colorado. (719) 783-0303 Free Consultation - Representing Clients Nationwide


Tracy Pride Stoneman is an attorney specializing in investment related complaints.Preparation of this article was assisted by Douglas J. Schulz, a registered investment advisor and former stockbroker in Colorado Springs