Investors often have the fear of missing out after watching an option play increase 1,000% in a matter of weeks.
We all crave the feeling of buying the perfect call option on a breakout stock or nailing a down move in the market via puts for a huge gain.
But our mind plays tricks on us. Investors never focus on all the times that an option expires worthless, and they never even imagine blowing out an account by going all in on an option that they thought would appreciate.
The reality of the options market is much different.
It is an ecosystem of sharks and barracudas, taking bites out of each other in an attempt to profit. The players are ruthless and only in it for themselves.
First, there are the highly efficient market makers.
These guys set market prices through their expertise in the Black Scholes Model used to derive an option’s price. They win in the long term by controlling risk and collecting the difference in the bid-ask spreads, and in exchange, they provide market liquidity.
The brokerage houses win big, too. They skim their cut off every trade and make out like bandits.
Finally there are the sharps or the professional option traders who squeeze out a profit over time.
Their strategy is the hardest to operate. They aren’t rewarded for providing order facilitation services like the other two participants.
Instead, they eat what they kill. Over the long haul, they can get as rich as the other two but only if they size up their strategy and/or attract investor money.
So who is bankrolling these winning players? Suckers.
The complexities of options aren’t well understood by most of the retail trading world. Nevertheless, they are highly attractive because of their limited downside, unlimited upside and embedded leverage.
Who hasn’t thought about buying that call option on the hot biotechnology stock? Or the way out-of-the money put on the SPDR S&P 500 Trust Exchange-Traded Fund that triples a trading account in a nasty crash?
The lucrativeness of the option market drives retail sheep to the slaughterhouse. They don’t know what they are doing, and so they consistently lose, funding the winners.
But don’t have to be a sucker like the retail traders.
Options aren’t magic, and they can be used to generate attractive returns. But they need to be used in the right way.
The first step to successfully trading options is clearing up common misconceptions surrounding them.
Misconception No. 1: Options can produce 1,000% returns.
It is nothing new: Internet marketers advertising “1,000% returns” in a few weeks on a call option. Or they pitch investors on a trade idea that will make a 500% return if XYZ stock crashes.
This sounds amazing to uninformed investors whose 401(k)’s have been clocking in at a measly 4% a year over the past few years. Their greed emotions start to run wild, but unfortunately, these emotional traders set themselves up for disaster.
It is true that options can offer returns of five, 10 or even 100 times in some situations, but such events are rare. And when they do occur, you need impeccable timing on both your entry and exit to realize gains of that magnitude.