How NOT To Make Money: Trading Stock Options

[SteveW]

This thread is for reader comments about my article "How NOT To Make Money: Trading Stock Options". It describes numerous reasons why options trading is rarely profitable.

You can start a new thread, if you prefer.

[SteveW]

A reader asked the following questions (edited, and identifying details removed).

Subject: Your article on "How not to make money in options"

• I am retired, and want to find a stock option trading strategy in order to make some money to supplement my retirement income by trading in my IRA account.
• I was drawn to trading options due to the influence of all the advertisements on how to turn $10,000 into $1Million in less than 5 years, etc.
• I signed up with a 100% money back guarantee trial subscription to [options newsletter]. They charge [$XXX] for 1 year of weekly advisory emails. They claim to use the same successful strategies that large Wall Street brokerage firms use.
• Can you tell me whether you have used other advisory services other than Value Line?
• Have you investigated whether any of the options advisory services are any good?
• If you have over 25 years of programming experience, you still cannot design a program to win.
• Also, the hedge fund you mentioned in the PBS program still failed even with M. Scholes and the other two experts. How can a small newsletter publisher advertise that they will make subscribers many, many times more than their investments?
• You advice may save me $$$ and disappointments. Your response would be greatly appreciated.  Thank you in advance.

To answer your questions,

The only advisory service I ever subscribed to was the Value Line Investment Survey (stocks, not options). It seemed pretty good, and is available in many public libraries for free. At the time, it had a good track record, which it might still have. But they don't promise huge returns, just fairly "normal" ones, slightly better than the market averages. At various times I also subscribed to Daily Graphs and Value Line Options, but both of those only provided statistics, not advice.

I have never used an options advisory service, but I personally am inclined to be skeptical of all of them on the grounds stated in my article: if they work so well, then why are the authors publishing a newsletter instead of making millions following their own advice?

The sales pitch on [website] about [newsletter] is so well written that it looks to me like carefully and professionally written advertising copy. But my question to them would still be the same: "Communicating with your subscribers is time consuming. If your options trading strategy is so good, why don't you just do that for a living? You only get $XX a month from each subscriber. Can't you do better than that by following your own options trading advice?"

Many options newsletters advertise that they will make their subscribers huge amounts of money. I personally do not believe that most subscribers to most newsletters are making huge amounts of money. I do believe that some newsletter writers are making a lot of money, while risking none of their own money in the options markets.

I've certainly written many computer programs, but I never tried to design one to "beat the market". My financial programs only calculated statistics.

The final decision is, of course, up to you, but I personally would not trade options to try to supplement my income, and especially not in my IRA to try to supplement retirement income. In my opinion, it is more likely to result in the loss of money you really need. I think that most financial consultants and retirement planners would probably say the same thing.

If it were me in your situation (which it is not), I would cancel my subscription to the options service and investigate other more conservative ways to make money, ones that are not "too good to be true".

However, if an experiment is worth $XXX to you, then you could keep the subscription, but trade only on paper for the first year. Yes, it will cost you $XXX, but at least you will know whether their strategies look promising or not. That's a fairly cheap experiment because in options trading (real trades, not paper trades), you can lose $XXX quite fast. So if you trade only on paper and then decide that their strategies don't work, you will have acquired that knowledge for only $XXX. If you make the trades for real, you can lose the $XXX plus a lot more.

I am not aware that the large brokerage firms on Wall Street actually make money trading options, and some large brokerage firms have run up gigantic losses in the financial markets. They are often not particularly good at trading. And hedge funds... well, you saw what happened to the one on the Nova program.

So although I recognize that options newsletter sales pitches often sound very attractive, I cannot recommend that anyone enter into options trading expecting to make money, and especially not with retirement income.

I'm sorry not to be able to be more positive, but options trading is marketed as a "get rich quick" scheme. If get rich schemes really worked, everybody would be rich. If options trading really worked, newsletter writers wouldn't have to work so hard writing newsletters and trying to get subscribers. They could just trade options.

[SteveW]

Another reader wrote:

I figured that since I found your website and saw how much effort you put into writing about your shortfalls in the options trading market, I must say I feel sorry for you. I'm making money in options, and I learned from someone who is also very successful at it. I've also lost lots of money but when a position goes against you, you CAN jump on the other side simultaneously and "catch up" with the opposite trade essentially balancing out the loss. In effect never losing money, either win or hold still.

Just a thought, good luck in your other ventures.

The strategy you suggest is basically a long straddle.

It sounds fine in theory, but it assumes that a position that goes against you will continue along its new trend which you can then follow and profit from. You can't count on that.

If the option price goes nowhere after you "jump on the other side" (which statistically is the most likely thing it will do), you lose whatever your losses were on the initial position, plus your entire investment in the second leg which expires worthless.

My question to you based on what you said on your website, "options lose value too quickly" why on earth did you not sell them?

The various option selling strategies require substantial financial resources. For every 1 option you sell, you must either possess 100 shares of the underlying stock, or have enough capital to finance a 100-share trade, which in some cases may be at a price that is arbitrarily high without any specified limit. To someone with large financial resources, option selling is nickel and dime trading in comparison to their total capitalization, and for someone without large financial resources, option selling can lead to financial disaster.

[nathanmeyers]

Excellent, excellent article that makes many good points.

However, I'll rebut one of Steve's assertions from the discussion thread: that writing options is not an interesting strategy. In fact, it's one of the few ways to reliably make money in options. It doesn't give you the swing-for-the-fences returns of options trading but, unlike trading, it actually works. Even Motley Fool has gotten into this game with an options advisory service, and much of their advice involves writing options.

The most common option-writing strategies require a willingness to own or buy the underlying stock, which means you have to start by choosing good stocks and understanding what they're worth. Sounds elementary, but that requires work that many options traders do not do: look for quality investments, not just for appealing price action or volatility. Simple strategies like writing covered calls and puts can turn boring holdings into nice income generators. It works because you're being paid to take reasonable risks, and because you're willing to take current income in exchange for capping your upside potential: that's a bet that you will usually win. More to the point, it works because you are selling assets that, most of the time, eventually become worthless.

Does owning stock in order to write options require "substantial financial resources", as Steve suggests? Depends how poor you are, I guess. After you've blown through tens of thousands of dollars gambling on options trading, I'd think boring old stock ownership would look like a bargain. As to whether writing options is "nickel and dime trading" to the well-heeled investor? It's not unreasonable to expect 10-20% and greater annual returns from conservative option-writing strategies in a flat market. Even the most well-capitalized investors should find that interesting.

For better or worse, retail investors like you and me are increasingly being lured into the options market. New brokers are popping up all the time, commission rates are falling, and even long-established conservative giants like Fidelity are pushing the advantages of options. Some investors will be lured into high-leverage, high-risk trading and make the same expensive discoveries that Steve did. But those who take the time to understand the risks and rewards, and are willing to substitute patience for greed, can do quite well in this game.

[geoff]

I agree with Nathan. Steve's assertion that "90% of option traders lose money" doesn't make sense when you think about it. Someone has to be receiving the money that those "90%" of people lose. And as it turns out, it's the option writers. They have the advantage because time is on their side; most of the time, they are selling something which will eventually become worthless. It sounds like Steve was mainly trying to buy options and then sell at a higher price before they expires, which is extremely risky and an uphill battle.

[ronmexico]

I happened upon your "article" and thought I should take time to respond. A lot of your assertions are just patently false, and I feel that I should remedy them. Full disclosure: I have traded options as a full time job for almost a decade, and I've managed other people's money. I should note that I don't take a management fee from the total account balance (as many do), I only take a manager's fee from the PROFITS for a year. So, if they don't make money, then neither do I. I hope to dispel some of fallacies surrounding many of the points you make, but some I do agree with. Also, I should mention that all of my positions are less risky than owning the stock outright, i.e. I am not a speculator. I have several income generating strategies that I use. I don't win every time, but I just try to make sure that my winners are more than my losers.

Let me start by saying that just buying options outright is almost certainly a losing venture. If you're making money in this manner, then you're probably just lucky. Also, options are not a "get rich quick" scheme. If someone is marketing them in this way, then RUN the other direction. Newsletters and such are notoriously untrustworthy, and you are correct in noting that they make their money from subscription fees. Now let me address each point individually.

1) I can't really respond to this one because it is only backed up with anecdotal evidence. I've never met anyone that was good enough to be a professional athlete, but that doesn't mean that professional athletes don't exist. You also mention that there is a Disclosure document that's required. The reason for this document is to remove liability on the brokerage's part. There is definitely more risk in trading options than trading stocks, and they want to make sure that you are aware of this (specifically leverage, delta, gamma, theta, and vega risk . . . ). If I were to use my own anecdotal evidence, I would argue that 80% of people I know that trade options are successful. Not very convincing, huh?

2) Again, anecdotal evidence at best. I completely agree that you should not trust newsletters, get rich quick claims, etc.; however, all of these things exist for stock trading as well. Would you also argue that no one can make money in the stock market? I don't talk about strategies I use because I want to continue using them for myself.

3) Just because one cannot improve at what they're doing doesn't mean that success isn't possible. I would argue that you didn't learn about trading options correctly (From the rest of your points, it appears that you only bought options). The old statement "practice makes perfect" is false. If I practice hitting in baseball by always holding the barrel of the bat, then no matter how much I practice, I'm never going to play very well in a pick up game. I might occasionally get lucky, but I am almost always going to be at a disadvantage.

4) This point is somewhat true, but just straight options purchases are a very small percentage of different options strategies. You have ignored all spreads (vertical, calendar, iron condor, butterfly, ratio, diagonal, double diagonal, etc) and strategies combining stock ownership with options trades (covered writes, collars, etc.). Also, you've assumed all positions are held to expiration. I can sell a call out early and recover time premium so that my loss is NEVER 100% of the amount I risked. Also, you have to consider that losing 100% of a $100 position (most of my positions have less than $100 at risk per contract) needs to be compared with the risk of losing the same amount of capital in the stock. Your comparison of 100% loss in the option and 100% loss in the stock is misleading. If you own 50 shares of the stock, how long does it take you to lose $100? It's not a 100% move that's required to lose that amount of money.

5) What you are referring to is Theta decay here. Theta is essentially the amount of money you gain or lose from holding the position for a day assuming every other factor stays constant. Of the literally hundred of options positions, some are negative theta (like you talk about); however, each one of those positions can be reversed which leads to positive theta (i.e. you make money from the passage of time). So, you are being very myopic here.

6) Most bid/ask spreads are less than $.05 now (a lot are even $.01 wide now), so this is not true. Also, options commissions are extremely cheap now (even at expensive Options trading brokerages like Think or Swim, the option commission is $2.95 per option or less). I trade with a different brokerage, and my YEARLY options commissions are under $200 for an account of 6 figures. That's not even significant. Poor execution is something that is up to you. Now you can watch both the Bid prices and the ask prices so you know what an acceptable price should be. If you disagree with the price, then don't trade that position.

7) In my personal account, I make around 20 trades per month (and I'm a professional at it). When I did it just for fun, I made around 5 trades per month. I'm not sure if you consider this frequent trading or not. Also, you can go as long term as you want (there are even 2 year options called LEAPS).

8) Maybe 20 years ago liquidity was low, but last friday there were over 250,000 options trades alone on the SPY etf (tracks the S&P 500). People should stay away from options that have low liquidity. You are right, there is nothing to gain in those situations. For most stocks with good volume, the options volume is very liquid.

9) Two words: limit orders.

10) This is a good feature. When option prices are out of line with stock movement, you know something is amiss. For example, options prices (read implied volatility) will often increase prior to take over rumors, etc. It gives you a leg up to see that something is amiss (something the retail stock investor would be blindsided by). You have to pay attention when you are making trades.

11) 100% agree with you here. Technical analysis is voodoo, and I feel like the only people making money off of pushing technical analysis are the people running seminars :)

12) Your argument here has nothing to do with options, but rather the stock market in general. Just because something works today doesn't mean it will work tomorrow. Options give you additional information that help you make more informed decisions.

Your related information really has nothing to do with stock options since LTCM used bond spreads to make their money. Also, the derivatives they used (Swaps and other interest rate derivatives) are not able to be traded by you and me (since they are traded OTC and not on exchanges). Their equity derivatives were not the source of their problems.

Any questions/differences of opinion, please feel free to ask.

[Puddinhead]

I forget where I read (in the 1970s) that most buyers of options lose money while many writers do ok.  So what did I do ? I wrote covered calls (in the 1970s) and I wrote them for a price that I thought it would never hit. WRONG, it often hits that price and the stock is called away and thus I lost the monies that I could have had if i had not sold the option. Don't sell covered calls in a bull market as the stock will be called away.

So many years went by and having learned from that mistake I decided to limit my covered call option writing to maybe .15c on several thousand shares.  My goal was not to make tons of money, but rather to make enough on a monthly basis that was realistic.  Result, I did much better, a few times I was called away but not as often as I was in the 1970s.

Then I got the idea of writing naked puts ! HUGH mistake, the brokers were keen to lend me monies so I could write lots of naked puts and when the 2000 market happened, the speed that my naked puts rose in value was so fast I lost $100k !
Margin calls were at my mail box every day for two weeks !

Then the last decade comes along and of late (2010) the market has been trading in a tight range, perfect for cash covered put and call writing. And if put the stock, I then sold a call at the same strike price. Result, much better.  No more margin, EVER.

I have been tempted of late to try bear call spreads, or even bear put spreads, but I chickend out and am happy with keeping the options I write maybe 10% higher (or lower in case of put writing) than what the stock is currently trading at.  Thus, in a tightly traded market, the stock maket has to drop 10% or go above 10% in order for my options to kick in (in theory).  As long as the underlying stock does not drop more than 10% or rise more than 10% than the option works, at least so far in 2010.

[davidNY]

RIDICULOUS, IGNORANT, AND FALSE ARTICLE

Here is some logic when your own post was devoid of it in so many places. Keep in mind that besides being a day trader, I have worked in the legal industry for over 16 years. And telling by your post, I am smarter than you.

Your statements in that article are subjective and one sided. Thus, they are bias. One major aspect that you failed to address is whether you conducted the proper FUNDAMENTAL and TECHNICAL research on the stocks you purchased options on. 95% of companies have poor fundamentals. Nor have you identified how you would research such stocks before investing. If you failed to conduct the proper fundamental research before you purchased the option, you are almost guaranteed to lose money. You didn't even address the fact that the PREMIUM paid for the option is less than actually owning the stock, which can save an investor a lot of money if the stock goes against them. What would be better? To buy a stock and see its price decline or buying an option and seeing the stock price decline? Buying the option has less risk. Plus, if you are going to exercise the option, you can hold on to the right to buy the stock while watching it perform. Personally, I have been making profits in the stock market as a day trader on almost a daily basis. Disclaimers are on stocks too. As for the fall of Long Term Capital Management company, your statements are so distorted and false. The company went out of business because of the Russian financial crisis (a/k/a Ruble crisis) that took their investments down because the Russian government devalued their currency and defaulted on its debts. It was their choice in investing in risky Russian BONDS NOT OPTIONS dummy that took them down. It was NOT the investments in individual company stock via options. The mere fact that you couldn't even make this obvious distinction shows that you are NOT as smart as you think you are. Nevertheless, it goes back to the fundamentals of your research. Many investors would never have invested in Russia; but many good investors invest in strong fundamentals and technicals instead. Unfortunately, you are NOT one of them. And telling by your writing, you will never be a successful trader.

Furthermore, the SEC requires stock brokers to warn investors of potential risks in the stock market because there is risk in the market NOT because Option trading carries more risk than stock trading. Another distinction you failed to make; but instead you distorted it. In fact, option trading has less risk than buying the stock outright. A smart child would know this. With options, you only lose your fee and NO MORE. But owning the stock, you can lose a lot more.

Here are some successful option traders that you did not speak to: Trader's Hall of Fame Larry McMillan,  Tom Sosnoff, Price Headley, voted worlds number one market timer David "FirstWave" Elliott, Ron Ianieri, Bill Johnson of Charles Chab. These investors were successful in options trading. Thus, when you infer that the options market is flawed because you couldn't succeed in it, you are applying your own failure to the options market and calling it broken when it is you who is broken.

As for losing money, of course you lose money in the stock market no matter if you are trading stocks or options. Only an idiot thinks you can make profits all the time. The issue is not about losing money, it is about cutting your loses fast and letting your wins ride. The more wins than loses you have can make you millions. Thus, your attitude about people losing money in the stock market as being a shocking revelation is the thinking of an ignorant amateur and a bad investor. Which your writing has proven you to be.

Therefore, I disagree with your amateur and ignorant outlook on the options market.


The bottom line is that you are a BAD INVESTOR like the majority of investors.


I CHALLENGE YOU

I challenge you to post the ticker of the stocks you purchased and the date here and I will conduct the fundamental and technical research. I will then post an in depth analysis of your stock picks.  I bet you selected stocks that have poor fundamentals and technicals. In fact, you never even mentioned anything about fundamentals or technicals when it is the first thing a good investor thinks about. You only mentioned reading books and practicing stock trading. This alone does NOT make you a successful trader. It just upsets me to see amateurs and ignorant people like you who think they know how to trade make foolish posts like this that scare people from a possible good path for them.

Those other people may be smarter than you in a way that would make them successful traders that you could never be. It amazes me how you judge other people on your own failing standards like the World only revolves around you...

I just think you're a fool who became a bitter loser because you were not good enough to make good profits in the market. So you wrote this ignorant and foolish post to turn people away from the market to make yourself feel better for being a loser.


Suggested reading: Avoiding Option Trading Traps with Larry McMillan What To Look For and Strategies for Success

[iwriteit2]

I'm 54 years old and have not had a full time job since 1997. I have made over 2 million dollars trading in options and I started with twenty thousand dollars my Uncle left me. As far as my losses are concerned they have been minimal. The one thing that I learned very quickly was this strive to be among the ten percent of the people that actually make money in the stock market, not the other 90% which us ten percent call the helpers.

There is a certain truth to your blog about losing money (The 90%) but if you stay away from all the late night get rich quick scams, the hundreds of books that tell you to quit your job and watch the millions roll in and just stick to basics you can make a tremendous amount of money. One last bit of info, I don't think I ever traded more then twenty companies in my whole life, I just keep playing them over and over again.

[mooregd]

Iwriteit2,
I and probably a lot of others, would sure like to know how you do it.  How did you pick the 20.  Is there a plan or a guru to follow that trades like you do?  May be a book? Any help is appreciated!

[artiecab]

I agree with Nathan. Steve's assertion that "90% of option traders lose money" doesn't make sense when you think about it. Someone has to be receiving the money that those "90%" of people lose. And as it turns out, it's the option writers. They have the advantage because time is on their side; most of the time, they are selling something which will eventually become worthless. It sounds like Steve was mainly trying to buy options and then sell at a higher price before they expires, which is extremely risky and an uphill battle.

I lost a lot of money trading options.  I don't know if I was addicted or mainly greedy.  I think I was addicted to greed because when I made a ton of money (thousands) winning, I thought I could do it forever.  Turned out it was plain luck.  Now, after 35 years, I'm getting back into the game (after all, it is a game).  I plan to stick with one stock initially (AAPL) and just follow the moving averages and volume.  I have been paper trading for months (knowing full well the differences between paper and actual) and made a lot of money.  I think lots of people not only make a lot of money trading options, but a ton of money.  I knew two guys who traded options.  One guy didn't know anything, relied mostly on luck, and the other guy just sold options.  He had a ton of money, which is what it takes to sell them because you have to back up your losses and the brokerage house won't let you sell more than you can lose in your account.  I don't plan on using any of the sophisticated trading games used in options, only buying, and only one stock at a time and no more than 5 contracts.  I have a plan to sell and buy back the option if I'm in a losing position and I have the amount in my head that I won't go over in a loss, such as $100 - $500 bucks.  If the option keeps rising on heavy volume, I will keep it til the volume tapers off and then sell it and wait for a while before I buy again.  Good luck to you traders who haven't made any money and to the ones who have mastered this game, keep up the good work.

[lucky]

I'd like to say that Steve's piece on options is 100% accurate.  It's everything that an individual needs to know about trading options:  If you play with options you can be 90% certain that you will lose money. Even if you get lucky and make some money you are part of a zero sum game, you're gambling, not investing or part of the system that capitalizes productive businesses. Options are simply a gambling vehicle attached to the stock market,  and despite arguments about "risk distribution", "insurance", etc., Stock Options play no important function in our economy, they're just gambling. But there is a Billion $$$ industry there that likes to pretend otherwise.

I also agree 100% with Nathanmeyers, re Writing Covered Calls.  I'm just back in the buy-write business after a 10 year break (I was busy with other stuff), and I've gotta admit I'm loving it.  I have nothing against gambling,  but I want to be the house, not the chumps across the table who "know" they'll get rich quick.  If anybody would like to discuss low risk - low reward buy-write strategies,  I'm all eyes. Just fwiw, what seem to be working for me are things like F, SFD, and TSN.  Different breed, but RMBS buy-writes,  7% in 52 days??? Stuff of dreams!

Cheers, Lucky