No. of Recommendations: 7
I believe the Fools usually have valid concerns about options, and their warnings should not be taken lightly. On the other hand, the Fools' lack of knowledge about options hurts detracts from their case.

Consider the first reason given for avoiding options:

Let's examine why I believe individual investors are little more than the fodder for the options market. First of all, unlike equities, there is no wealth creation at all in options. As such, in any options trade, one of the two participants MUST be wrong. In investing it is not necessarily the case. Because investments in equities are essentially entitlements to future earnings from a company, it is possible for both the buyer and the seller to be correct in a trade. If I sell my Intel (Nasdaq: INTC) because I believe it will go up less than 10% per year, but someone else buys it because he thinks it is safe and it goes up 8%, we are both correct.

Not so in options. There is a fixed amount of value in options, and each one eventually expires. Actually, in options it is possible for both participants to lose, because neither may gain enough to cover broker commissions. Look at it this way: If there is a town where the only economic activity is for people to buy umbrellas from one another, eventually the whole town will in fact be broke. There is no way for options writing to generate value. Actually, it's a highly valuable line of business for the brokers -- they get to keep the vigorish on the options, leaving the options traders worse off collectively by several billion per year.

This flies in the face of the whole reason that people buy or sell options. People "write" options against individual stocks. The theory is that if the buyer does not exercise the option, then the seller gets to keep the dividend and the purchase premium. If the option is exercised (meaning that the buyer chooses to either "Call" away the stock from the seller or "put" the shares to the seller), the theory is that the seller still comes out ahead from a combination of the dividend and premium.

Once again, under this structure, one of the two principals MUST be wrong.


There are two implied, and incorrect, assumptions.

The first assumption is that options trades are made based primarily on the expected direction of movement of the underlying stock. This may be true for many newbies, but I think most people who trade options for any length of time soon learn that option trades are best based primarily of the expected volatility of the stock.

The second assumption is that most trades are purely speculative and totally unhedged. In reality that is usually not true. Most option trades are between a retail customer and a market maker (or specialist). The market maker's trade will usually be hedged and the retail customer's trade is frequently hedged. Let's say a stock is selling for $50.00 and I buy 10 calls with a strike of $50.00 for $5.00 each, for a total of $5,000. The market maker will be short 10 calls and is likely to buy 500 shares at $50.00 as a hedge. Oversimplifying by assuming no adjustments are made prior to expiration, I make a profit if the stock is over $55.00 at expiration and the market maker makes a profit if the stock is between $40.00 and $60.00 at expiration. Anywhere between $55.00 and $60.00 we both profit. The idea that one of the two principals MUST be wrong is simply incorrect.

There is only on other significant reason I see in the article for avoiding options.

Since there are no value-creating events in options writing, you are necessarily left to compete against everyone else in the field. This is the main reason why we believe individual investors need to steer clear of options: You are really, truly investing with and against the big boys in a market.

IMHO, this shows a lack of knowledge about the option markets. You are not competing with "the big boys" per se. Go back to the example I gave where I bought 10 calls for $5.00 each. If the stock ends up at $56.00 per share my $5,000 has turned into $6,000 giving me a 20% profit and the market maker's $20,000 investment has turned into $22,000 giving him a 10% profit. The big boy (the market maker) and I are both happy. How did we both make a profit in a "zero sum" game? We made it from the stock owner who sold 500 shares of the stock at $50.00 per share shortly before it went up 12% to $56.00 per share. The $3,000 profit generated by the increase in the stock price was split between us. Trying to separate derivatives of any sort from the underlying securities is demonstrating ingorance of the market.

I do agree with the comments about the "human tendency to place more weight on recent experiences than more distant ones." and, quite frankly, I have not written a lot on this board recently because I have not been doing much option trading recently. I do not feel I am in a good position to factor the current uncertain times into projections of future volatility. I do not, however, agree with the comments about options being "so bloody complicated" that retail investors should be discouraged from trading them. (I hope this article was not published on the UK Fool.) I simply believe that retail investors should be well educated before trading them.

Good Luck,
Z
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