Is Options Trading a Fool’s Game?
Bryan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Options trading has always been a bit of a pariah in the investment world. For the most part, it’s considered by the financial community as a pursuit too complex and dangerous for anyone except the professional trader. Even investing legends like Warren Buffett and Peter Lynch have nothing good to say about it. Lynch once wrote, “Warren Buffett thinks that stock futures and options ought to be outlawed, and I agree with him.” He went on to say, “I don’t understand futures and options myself,” - an important qualifier, and true of any investing opportunity whether it be stocks, bonds, real estate, or pork bellies - you should never trade what you don’t understand.
Unfortunately, the vast majority of options traders pay no attention to this. They are seduced by the casino-like returns and leverage options offer, and buy them without considering their odds of winning …and the odds usually aren’t good. Most out of the money options will expire worthless - the kind commonly purchased by the unwary - with some having less than a 10% chance of ever paying off. They are on the wrong end of a very lopsided playing field. These are the options Lynch was talking about and if you buy these, you’re probably better off playing slots.
Zero Sum Game
Each options transaction involves a buyer and a seller. Every dollar the buyer loses is a dollar in the pocket of the seller, and vice versa - so options trading is referred to as a zero sum game.
Now things get interesting. The same option mentioned above that has only a 10% chance of paying off for the buyer, will profit the seller 90% of the time. Because options are a zero sum game, a crummy investment with virtually no chance of profiting on one side, means an excellent investment with a huge advantage on the other.
Don’t misunderstand this as an endorsement for selling naked options. It has pitfalls of its own, and can be dangerous if you don‘t stay on your guard. Negative risk/reward ratios are possible if the market moves quickly in the wrong direction and you don’t close or modify your position. But there are ways to mitigate this risk and still put the odds in your favor.
One way is through covered call writing. This is simply selling call options against stock you already own, and creates an additional income stream as you collect premiums from the call options. Let’s look at an example, with commission costs and taxes left out for simplicity.
Apple (NASDAQ: AAPL) w trading at $572 recently. There are a huge number of call options available on Apple, but you want something fairly short-term that gives you a comfortable cushion between the stock price and the call option strike price. The September $620 call trading at $5.05 fits the bill. It expires in less than 2 months, gives you 48 points between the stock and strike prices, and puts $505 in your account. If you do the math, the $505 equals an annualized return of 5.3% and offers protection if Apple falls to $567 - which granted isn’t much, but if the stock falls and the option expires, you keep the money. In fact, you keep the money no matter where the stock price heads. The premium is an immediate cash infusion for selling the call. Your best case scenario is Apple rising to the strike price of $620 at expiration - a $5,305 profit from stock gains plus the call premium with no further obligation on your part.
So what’s the worst case scenario? Well, the greatest risk is that your stock tanks - true regardless of whether you use a covered call strategy or just own shares. The other possibility is that Apple shoots upward past $620 and your shares are called away. You are now obligated to sell 100 shares at $620 no matter what the current market price is. The call has effectively put a cap on profits at levels above the strike price. If this happens, you may no longer be an owner of Apple stock, but you realized a $5,305 profit in 2 months and a 55% annualized return.
Options trading doesn’t have to be a highly speculative investment that looks more like gambling than investing. It’s completely up to the trader, and can be very conservative. The skilled tactician has almost unlimited flexibility to design strategies that limit risk and maximize profits.
But all investments require knowledge and due diligence. Buying options that have little chance of ever becoming profitable is the market equivalent of playing the lottery, and deserves its bad reputation. Traders who don’t fully understand them are treading some dangerous waters, but options trading could prove to be a profitable game for the disciplined, educated Fool.
bstinde has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.