September 6, 2021

Career AdviceMarkets & Free Enterprise

Use Caution before Investing in Options

By: Daniel Huizinga

A few years back, I was planning a personal finance presentation for my colleagues highlighting the importance of low fees, diversification, and passive investing. One of my colleagues wanted to add a slide about how she enjoyed trading options. At the time, it seemed like a harmless topic to discuss, but now stories are widespread of everyday (“retail”) investors losing significant amounts of their savings by betting on options. Unfortunately, though some are sounding the alarm, the growth of Robinhood means we will keep hearing more of these stories. 

What is an option? In essence, buying an option on a stock is a bet on its future price. If you buy a “call option,” you pay a fixed price today for the right to buy a stock at a future date at a set price (the “strike price”). For example, let’s say a stock is currently trading at $50. You might pay $3 for a call option to buy the stock for $52 at any point in the next 30 days.) If the stock goes up more than $2, you can buy the stock at $52 and sell it for the new price, making the difference in profit. However, you only make a profit if the stock goes above $55, covering the initial $3 premium you paid for the option. And if the price doesn’t go up past $52 during the timeframe, the option expires worthless and you lose the $3 you spent on it. (Buying a “put option” is the reverse, where you buy the right to sell a stock at a fixed price and bet that the price falls during that time frame.)

You can sell options too (you receive the premium today and sell someone the right to buy or sell the stock at a future price) but even options traders recognize that this is “the single most dangerous move you can make… [with] infinite potential losses in exchange for limited potential profits.”

Sounds fun, right? It’s like gambling – you might make a lot of money if you’re right, but you also might lose all your money if you’re wrong. Unlike owning a stock that might continue to go up or down, an option is worthless once its time frame expires. Because options are cheap relative to a share of stock, people also often buy tens or hundreds of them at a time – meaning they can either make or lose a lot of money very quickly. According to Nerdwallet’s advice for beginning options traders, unless you “know the company’s business inside out and have a clear sense of which direction the asset is heading” , you’re really just making a guess.

These guesses can lead to catastrophic outcomes. Institutional Investor recently profiled several millennial investors who lost hundreds of thousands (or even millions) of their life savings after buying options on Bill Ackman’s special-purpose acquisition company. “I considered this a safe, calculated bet,” one investor said. The article is less generous: “Egged on by chatter on Reddit and Twitter, [these investors] took the YOLO mantra to heart, borrowing on margin or buying cheap but risky call options that could offer mouthwatering returns.”

Shortly afterward (without getting into the business details), the price of the company unexpectedly tanked, and the investors lost everything as their call options expired, worthless. As they struggle with the realization that they lost everything, their quotes are painful. “I’m not mentally there. I’ve got to pick myself up or this is going to ruin my life even further,” says one. “This is the worst thing that has ever happened to me,” comments another. 

It’s not like this news is surprising. We’ve known for years how dangerous options can be. “Trading options is one of the all-time suckers’ bets,” said Whitney Tilson, a hedge fund founder, to Investment News back in 2010. “Most experienced professionals lose money doing it. It’s virtually certain that inexperienced, individual retail investors will lose money doing this.”

Yet despite these warnings, options have never been more popular. Last fall, Barron’s highlighted a massive increase in options trading by retail investors, and the trend has continued this year with the meme-stock craze. Robinhood, perhaps the most popular stock-trading app for retail investors, tripled its volume of option trades last year and its largest driver of revenue last quarter (40%) was options trading. 

“I suppose that the stock market has always provided opportunities for compulsive gamblers, but it does feel like those opportunities are heightened these days,” argues Matt Levine, a finance journalist.

Though it can be tempting to take a shot at getting rich quickly and chase the thrill of a lottery ticket, remember how quickly you can lose it all if you’re wrong. If your goal is to build long-term financial stability, don’t bother trading options.