Let's discuss the rarely mentioned downsides to options trading.
The reason no one talks about these pitfalls is that it's against the system's best interests. The system wants retail traders churning their accounts at brokerages with tons of options trades. The more trades, the better.
Brokers earn fat commission fees and their affiliates that market for them get a nice cut too. Market making firms make a killing from the large retail order flow. And programs like CNBC can garner audience engagement by fascinating the public with their "sophisticated" options trades.
But understanding these pitfalls are key to ensure your success in the options market.
Pitfall No. 1: False Confidence And The Folly of Sophistication
False confidence in anything is dangerous. This is especially true in options trading. It's a silent killer that leaves its victims demoralized and broke, slamming drinks at the local bar, wondering where it all went wrong…
So how does false confidence infect an option trader's mind?
It starts when an investor first learns about the plethora of option spread trades available to him. These spreads have a bunch of cute and fancy names, making them all the more interesting at first glance.
You've probably heard of some of them:
- Put spreads
- Call spreads
- Vertical spreads
- Iron Condors
- Iron Butterflies
- Calendar Spreads
- Ratio Spreads
- Back Spreads
- Covered Calls
- Double Diagonals
And the list goes on…
The option "gurus" tend to whip up new ones year after year too, just to hold the interest of unsuspecting investors and traders.
Now we're not going to go into the nitty gritty of what each of these are. Most of them are garbage and don't matter unless you're an options market maker anyway. But that doesn't stop average retail traders from getting sucked in.
When they first start, they get excited about figuring out what these different spread trades are. And after they can finally recite them from memory, they start to think they know something.
This is where the danger begins.
These spreads are very complex. Just knowing what they are is not enough to successfully use them. But novice traders don't realize this. Instead, they mistake their basic understanding of options spreads as skill and start to fire off trades like mad men.
I know this because I did the same in the very beginning of my options trading career.
Sophistication and complexity do not imply an edge.
In trading the opposite is usually true. A simple process is more likely to have persistent edge than a complex process. Don't confuse the fancy structure of these option spreads with an actual edge in the markets. Just because something is complicated, doesn't mean it will make you more money. In fact, you may wind up losing your shirt instead…
Pitfall No. 2: Commission Intensity
Why are all those spread structures that we mentioned above mostly worthless to retail traders?
Because all they do is run up commissions and add next to no value.
The primary goal of a spread is to hedge or reduce your exposure. You're not really trying to add anything new to your book with this strategy. But novice traders don't understand this. They try to place bets with spreads anyway.
And of course the brokers never mention this - they're too busy getting rich off the fees.
Take the bull call spread for example.
The bull call spread is constructed by purchasing one call and then simultaneously selling another call at a higher strike. Buying the first call gives you exposure to the underlying price going up. But selling the second call gives exposure to the underlying price going down. These two positions clearly contradict themselves if you're trying to bet on direction.
Consider a hypothetical 208/210 call spread in SPY.
The 208 call is trading for $3.25 and the 210 call is trading for $2.18. You can buy the 208 call and sell the 210 call for a net debit of (3.25 - 2.18) or $1.07.
The maximum total value this spread can reach is $2.00. (Width between the strikes of 210 and 208.)
The maximum amount of profit you can make on this trade is ($2.00 - $1.07) * 100 or $93. The max you can lose is $107, or the cost of the spread.
Since a vertical spread consists of two options, you have to purchase two contracts to complete the trade. Using a standard commission rate of $1.00 per contract would cost you $2.00 in total.
Spending $2 in fees to make $93 is terrible. This may be hard to see at first. But add in a realistic win rate on this trade of 60% and it becomes clear.
The win rate can be used to calculate the breakeven rate which comes out to 53.5%. So we're giving ourselves a hefty 6.5% edge (60 - 53.5).
If this trade played out 10 times with that 6.5% edge, it would look something like this:
- Trade 1: -107
- Trade 2: 93
- Trade 3: -107
- Trade 4: 93
- Trade 5: 93
- Trade 6: -107
- Trade 7: 93
- Trade 8: 93
- Trade 9: 93
- Trade 10 :-107
- Total Profits: $558
- Total Losses: $428
- Gross Profits: $130
- Commissions: $20 (2 dollars a trade times 10 trades)
- Net Profits: $110
Commissions cut over 15% from your bottom line! And that's with a cheap commission structure, strong edge, and an assumption that you let the spread expire. If you exit the trade before expiration, that will rack up another 2 dollars per trade, bringing total commission costs to $40. That only leaves a net profit of $90 - an over 30% reduction to your bottom line!
You can see how these commissions add up. A cost structure this high will send even a highly skilled trader to the poor house.
The economics get even worse as you tighten the option spread (use strikes closer together) or add in even more legs (a leg refers to one part of a spread). Some option spreads require 4 legs to execute!
You can spend far less in commissions on a futures contract or outright stock trade for much larger upside.
Pitfall No. 3: A Zero-Sum Game
Another important "hidden" risk to understand about options is that they're derivatives and therefore a zero-sum game. (Negative sum when commissions and the bid ask spread are included.)
This means that whenever you take a position, someone else is taking the other side. That other person could be a retail trader, bank, commercial hedger, market maker, HFT firm, or professional proprietary trader. If you win, that other person loses. And if you lose, that other person wins. It's a constant battle of wits between market participants. And of course the middlemen take their cut along with Uncle Sam after it's all said and done.
With stocks and bonds the story is a little different. It's not necessarily a zero-sum game. The pie can theoretically grow so every investor wins.
When you're invested in a company, you're entitled to a portion of its assets and a portion of its income through dividends. All holders of the company's stock win if it sells more widgets and earnings grow. You can theoretically get paid higher dividends while the assets you hold become more valuable.
Look at the Dow since the early 1900s. Everyone was a winner as long as they held stocks long enough.
The same thing is true for long term holders of sovereign bonds. An investor gives his money to the government and over the course of 10 years or so he receives his original investment and then some. The government wins from the financing it receives. And the investor wins because his cash earned some extra income.
So before you fire off that next option trade, remember: it's you against them. Someone will lose. And you're usually playing against a professional operator who relies on making profitable option trades to feed his family.
When framed in this context, the amount of trades I took in the options market plummeted. It's a matter not to be taken lightly.
Hopefully this discussions has cleared up a lot of the false advertising and BS claims out there. With this basic understanding of the pitfalls of options trading, you're ready to move to the next step - understanding and trading option volatility. We created a special report covering this very topic. You can check it out here.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.