Who Gets Rich with Options?

I picked up my local Sunday paper this morning and glaced at the lead story in the business section: "Bet on the future with options." As I scanned the article, I learned that options volume is now 5.6 million contracts, up about 1 million contracts (or 22%) from a year ago, according to the CBOE. Apparently the "little guy" is getting involved, writing covered calls, buying protective puts, and speculating with naked calls and puts.

I'm glad to see that more people are participating in the markets. However, unless this is just another dose of sensational journalism, we can be certain that the proverbial "little guy" is once again getting "fleeced" by seminar speakers, brokers, and financial professionals, who peddle products for fees and commissions and hardly give a second thought to pulling the wool over the little guys' eyes.

Let me explain my stance. First and foremost, options (along with futures and other derivatives) are a "zero-sum" game. For every derivatives contract, there are a buyer and a seller, who take positions on opposite sides of a market (stocks, bonds, currencies, commodities, etc.). As time passes, the market moves, and, when the contract expires, one party has a gain while the other has an equivalent loss. In other words, for every winner, there is a loser.

If that were the whole story, I wouldn't be so negative. Importantly (and this is the part that usually goes unmentioned), there are third parties involved who always come out ahead in the game. Brokers take their commissions, market-makers extract the bid-offer spread, and advisors (to the extent that they are involved) earn their cut. So, if a net amount (upfront premium plus final settlement) of $100 changes hands during the life of the contract, the losing party is worse off by $100, the winning party is better off by, say, $95, and the brokers, market-makers and advisors end up ahead by the remaining $5.

Because the fees and commissions in options trading are so much higher than in trading the underlying stock, and because options contracts are all by their very nature short-dated (volume becomes very thin beyond a few months), the annualized frictional costs for even moderately active options traders can easily run beyond 5% or 10% of the principal amount of the underlying stock. A hurdle this high is very difficult to surmount for any options players hoping to realize consistent profits.

Now, there are many who believe that they have a "knack" for guessing short-term market direction correctly and, consequently, can benefit from the leverage opportunity that options provide. Then, there are others who advocate the insurance aspects of buying puts or selling calls to reduce the volatility of underlying buy-and-hold positions. To the short-term market-timers, I say "best of luck"--in my opinion, making consistent profits in options trading, particularly with the high frictional costs, is as difficult and unlikely as winning consistently in Las Vegas. My rebuttal to the insurance argument is simple: Make sure that you really need the insurance against market volatility before you buy it--short-term profits are, of course, possible on the options component if you happen to be on the right side of the market, but in the long run you will likely be better off just riding the market's rollercoaster, without trying to smooth the bumps with calls and puts (and suffering from the frictional costs).

My advice is straightforward: Avoid options and save on fees and commissions. Accept the volatility of the market, patiently letting the market's secular rise propel the value of your portfolio upward over the long haul. There may be a few professional traders who have enough of an "edge" to profit consistently from options trading, but, if you're a little guy, the options cards are stacked against you from the start.