Investing in options – a good idea?

Most individual investors take long positions on stocks within their portfolios. They buy Apple shares (AAPL) and hold the shares expecting (hoping?) they will rise in value (price) over time. At some point in the future the stocks are sold and a capital gain is realized. Fewer investors take short positions, mainly because they don’t really understand the mechanics of shorting stocks, but essentially there is a symmetry between these positions that make them more alike than is nornally thought. Even fewer investors trade options, and of them a fraction understand how options work.

I am constantly surprised that so many people I meet tell me they are investing in options. Options are risky, but through leverage offer the potential for high returns. There are many online shills happy to tout the profits possible through trading options, usually by subscribing to their guides and newletters, or buying their software. They are quick to debunk the myths surrounding options. But the truth of options trading is in the mathematics of the market, which differs from the mathematics of the standard stock market. Options belong to the family of derivate – contracts with value determined by the value of underlying securities. The stock market deals with those underlying securities, including shares in the ownership of publicly traded companies, but the options market deals in contracts written on those underlying securities.

An option is a contract written between a buyer and seller. The buyer gets a right and the seller takes on an obligation. In return for the right (to buy or sell an underlying security), the buyer pays the seller a premium. In return for the premium, the seller has the obligation to fullfil the contract if it is exercised. Options can act as insurance, or a hedge, against adverse changes in a related position in the underlying security. But a lot of options trading is purely speculative and traders are expecting to make money either by selling options that go unexercised, or exercising options that are in the money.

While holding stocks provides positive returns on average, and in the long run, options trading is mathematically a zero-sum game. ( Every dollar “won” in an option trade is a dollar “lost” by the other party to the contract. Given this fundamental nature of options trades, the only way an investor can make profits in the long run is to be smarter, or luckier, than the other investors. If you believe you are smarter, or luckier, than the average options trader, then I wish you all the best. Otherwise, my advice is to take your money to the casino, and enjoy the free drinks…