May 11, 2008

A Very, Very, Very Bad Option

BEFORE I WENT TO SLEEP last night, I was reading the financial news on the wires and stumbled across a rather alarming article from the Associated Press. This article, which Associated Press business writer Joe Bel Bruno wrote, reports that many brokerages, seeing options trading gain in popularity among investors, are encouraging their customers to accordingly start getting involved in options.

My reaction to this news can be summed up in one word -- and that word, said very loudly and in slow motion, is: Noooooooooooooo! This is not because I think options are an inherently bad thing -- they do have their uses -- but because I don't think they're a good fit for most investors, particularly small investors or those investing with a focus on the long-term. But let's look at Mr Bel Bruno's article to get a lay of the land:

For Kim Snider, it only takes one word to send participants in her monthly investment workshops into a near panic. The Dallas-based financial adviser gets the same reaction, without fail, every time she suggests using options as a way to protect stock portfolios and make money.

"Peoples' eyes roll to the back of their heads; they are absolutely horrified," she said. "There is still a pervasive myth that options are complicated and risky."

That might be quickly changing. The options market once baffled investors who felt using puts and calls to bet on stock moves was tantamount to a Wall Street craps game. These days, online brokerages and financial advisers are pitching more investor-friendly ways to use options -- and that's led to a significant growth in their popularity. ...

One reason for the options boom is that more individual investors are managing their investments online; options are more readily available on the Internet than when they were sold through brokers in the past. Options also feed on Wall Street volatility, which has gone up significantly in the past year.

"There's been a tremendous adoption wave among self-directed retail investors of options trading," said Don Montanaro, chairman and chief executive of Boca Raton, Fla.-based brokerage TradeKing. "The savvy and wisest investors realize they'd gone through a whole market cycle where they adopted taking care of their own investments online, but did so with a limited amount of plays. People only knew how to buy and sell stock."

For the most part, Montanaro said education has been the biggest priority in persuading his customers to use options as a tool. It's little wonder, because options contracts -- which turned 35 this past week -- were once exclusively traded by big institutions inside of Chicago's boisterous futures pits.

TradeKing customers last year were mailed a step-by-step "Options Playbook" that helps instruct them on how and when to employ the investments.

Now, let's look at how Mr Bel Bruno describes options trading:

The basic premise of stock options contracts is that investors bet on a stock's direction and price within a specific time frame. For instance, investors who predict Google Inc. shares will vault $100 to $600 can lock in such that wager and hope it rises.

At the end of the contract, that would give them the right to pay only $500 when everyone else is forced to buy at a higher price -- giving them an instant profit. However, stocks could easily move the other way and leave investors forced to cover the difference. Options are also used on other investments, such as commodities.

I know some of my readers will have immediately noticed the mistake in Mr Bel Bruno's example of how options work, and I would submit it as Exhibit A as proof for why only sophisticated investors should consider using options as part of their investment strategies. I mean, if the reporter writing the story can't adequately describe them -- or, more likely, the copy desk made an error in boiling things down -- that should be a warning sign as to the complexity of these things. (A discussion of their complexity follows -- if you're not interested, scroll down past it).

OPTIONS: The Craps Table of the Investing World,
Without the Spectacle of That Guy Shouting for a Hard Eight

That said, Mr Bel Bruno got it right in the first sentence of his description: "the basic premise of stock options contracts is that investors bet on a stock's direction and price within a specific time frame." This is true. But Mr Bel Bruno's description of a "call option" -- the most basic of options transactions -- wasn't spot on.

A "call option" gives one the right to buy stock at a given price within a certain time frame. For instance, Google is now trading at $573 per share. You think the price is going to go up. However, you don't have the capital to buy Google shares, because they're trading at $573. So, what you can do is buy a call option (or options) to place your bet accordingly.

Let's say you think that, by September, Google will rise to $650, and as a result you buy two call options. These options are now trading at $26.70 per share, which is how options contracts are priced. An option contract covers 100 shares. Thus, your two call options will cost you $5,340 ($26.70 x 100 x 2), plus commission -- at my brokerage, these are nominal: it would cost about $10 to buy this, which isn't bad at all.

Now, let's say in June, Google announces its latest secret project will revolutionize, I don't know, the way people buy coffee. The price of Google now jumps to $670, and the price of your options jumps accordingly -- let's say to $70 or so. $20 of that price would reflect the value of the option -- since the option is $20 above its "strike price" of $650 -- and $50 would represent investor sentiment that Google would go even higher, thus making the option even more valuable. On the underlying value of the option, you would be up $4,000 -- and if you sold right away, you would make $13,990 ($14,000 - $10 commission).

But -- and this is a very big but -- let's say you hold on and the price of Google drops to $610 in August based on, I don't know, trouble with the coffee-buying project. Your option is now inherently worthless, because people can buy the stock for $610 and not turn to you to buy it for $650. Since there's only a month left before the option expires, and market sentiment has turned against Google, the price of your option falls to $15. You're now down $2,340. ($15 x 100 x 2). And if you hold on until the option expires -- and it's still not in the money, you're out your entire investment of $5,340, with no chance to get it back. It's done, gone, an ex-parrot. Stick a fork in it.

Given this, it might have made more sense to have taken your $5,340 and purchase eight shares of GOOG, which although not as exciting still would have given you a profit of $296. (8 x ($610-$573)). Plus, of course, you'd still have the shares, which you could hold as long as you wanted.

This is a very optimistic scenario I've set out, as you can imagine. After all, if you bought the options at $26.70, and Google tanked for the next month, not only would you be out of the money, the speculative value of your options could plummet as well. You'd then have to rely on the stock recovering to make any money. If the option expired worthless, you would not have to cover the difference -- Mr Bel Bruno's mistake -- but you would be out a lot of money. (There are cases in which you would have to cover the difference -- a highly risky strategy known as writing (selling) "naked calls," in which you didn't have the shares to write the option but did so anyway, requiring you to pony up for them when the option expires. But most people writing options have the shares to cover them -- although one could also argue this is dumb).

PUTS, NAKED CALLS, and MORE:
Being that Joyless, Rotten Bastard at the End of the Table
Who Bets the Don't Pass and Profits From the Misfortune
of Everyone Else Playing

Now, the call option is the most basic option to understand. You can also buy a put option, which is the opposite of a call option: you're essentially betting the stock price will go down. (It's similar to short selling a stock).

Getting more advanced, you can sell ("write") a call option, either with (a "covered call") or without (a "naked call") holding the underlying shares. This is extremely risky. If you hold the shares, and the option goes "in the money" for the holder of the option, you'll have to sell your shares at the strike price. Using our above example, if you sold (wrote) a call option on GOOG at $650, you would have to sell your 100 GOOG shares at $650 if the shares went above that, meaning you'd be out whatever profit you could have realized from the higher price. If you didn't have the shares, you'd have to buy them at whatever price they were at, which would leave you in a world of hurt. You can also sell puts (again, covered or naked).

The basic idea behind this strategy is that you would gain income from the options -- using our above example, you would make $5,340 through writing two GOOG call options -- but only if the options were out of the money when they expired. If the price of GOOG shot up to $700 per share, you would lose out on $50 per share when the option was exercised, because you'd have agreed to sell your shares at $650. That would leave you with lost profit of $10,000; after subtracting your option income, you'd have lost $4,660 on the deal. If you wrote a "naked call," you'd have to come up with $140,000 to cover the 200 shares of Google you'd agreed to make available to the option holder. I don't know about you, but for me this would really suck.

There's one other strategy I'll discuss before moving on -- that's known as a "married put." Let's say you own 100 shares of GOOG at $573, and you buy a put option at $550. The value of your shares is worth $57,300. The cost of the put option, which expires in September, is $3,920. If GOOG shares fall to $500 in August, you'll make at least $5,000 on the put -- and probably a lot more -- which offsets your equity loss of $7,300 in the stock itself. The idea is to hedge against loss in the value of your underlying equity position; however, the flip side is that if GOOG goes up, you'll have wasted $3,920 on your put, which will be worthless.

IN SUMMARY: Why Options Are
Not the Right Option for Most People

At the start of Mr Bel Bruno's article, there was a quote from a financial adviser who said it was a "myth" that options are complicated and risky. Well, it ain't no myth: they are complicated and they are risky. Nearly everyone should stick with investing -- not wildly speculating on future events that may or may not happen. There are plenty of ways to wildly speculate on things without putting your hard-earned investment capital at risk. Remember, it took a lot of hard work to earn that capital in the first place -- risking it on options doesn't make all that much sense.

But Bennnnnnnnnnnnn, some of my readers are saying. What if I just use them as a hedge against my shares falling? Well, what about it? If you're investing for the long term, then swings in market prices shouldn't concern you all that much. More importantly, though, you're eating into your returns by wasting money on options. If the worst doesn't happen, and the stock you buy goes up, you'll make money -- but not as much as you could have, because you had wasted money on buying your hedge, which would now be worthless as a result of the stock price going up.

As for the brokerages -- well, of course they want their customers to buy options, because that boosts their bottom lines. After all, with commissions for most vanilla stock trades practically nothing, allowing customers to trade in options means more business for them. Companies such as TradeKing don't send out "educational packages" out of the goodness of their hearts -- they do so because they think it will mean more revenue.

Finally, readers undoubtedly noticed in Mr Bel Bruno's article the historic comparison of options to a craps game. Folks, the comparison was made because it's true.

Speaking of history, craps itself is a simplified version of an old medieval dice game which had the very appropriate name of hazard. Hazard. Keep in that in mind the next time someone at a cocktail party starts babbling on about how much money they made with options. That someone may have avoided the traps for now. But over time, I would suggest most people speculating on options will find out the hard way that the house always wins.

ADDENDUM: Futures Options, or:
How to Lose Less Money on Commodities

Oops -- almost forgot! One place where using options makes sense is when one speculates on the commodities markets, but only because it's slightly less crazy than screwing around with commodities in the first place. If options are the craps games of the investing world, then the commodities markets are the pai gow tables. You know, those tables where the Chinese play dominoes based on an incredibly complex series of rules and traditions that no one unfamiliar with the game could ever figure out unless they spent months at it.

Anyway, futures options -- also known as "futops" -- are a way one can limit one's losses speculating in commodities, because you'll only lose the underlying value of the option when you inevitably end up down-limit on pork bellies or something. Of course, in screwing around with commodities, you're violating Rule No. 4 of Basic Investing Principles, which is: "Don't Screw Around with the Commodities Markets, Because They Can Make Your Life a Living Hell." So just as you would smartly avoid speculating in commodities, you should smartly avoid speculating in futures options based on those commodities. Still, if you must lose all your money in commodities, you could lose it slower through using futops as opposed to actual positions in the commodities themselves.

Posted by Benjamin Kepple at May 11, 2008 11:45 AM | TrackBack
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