Jonathan Huffman, development director for an art museum, writes:

“I would appreciate your thoughts on investing in options. Last year I took a $4,000 initial investment and turned it into $75,000. This year, performance like that has been hard to match, but I’ve learned a few lessons and, hopefully, have some skills to bring to the practice of investing in equities options.

“I am not the only individual investor who has discovered the profit (and loss) potential of options and this is evident by the dramatically increasing numbers of options investors (as observed in the increase in small scale options purchases and subscriptions to options-oriented publications).

Do you purchase options yourself? [Occasionally.] and, if so, what criteria do you utilize for their selection? [Not yours, apparently, or I’d have done much better!] If you do not trade options, why not? Do you find the increase in the number of individual investors trading options to be disturbing from the standpoint of this phenomenon’s indication of excessive speculative activity? [Yes.]”

A lot of people play the lottery, too — a few with considerable success. The odds with options aren’t as bad, but they’re not good.

The fundamental difference between stocks and options is that with stocks, everyone can make money, because they represent shares in productive assets. Diversify a bit, and no one has to lose. It can be said with confidence (though no absolute guarantee) that someone who today puts $4,000 into a mutual fund will have considerably more money 20 years from now. With options, you’re not making a productive investment, you’re placing a bet. It can be said with confidence that someone who puts $4,000 to work in the options market will have none of it left in 20 years. And that he will have expended considerable energy, actual and psychic, losing it.

With options you are in a less-than-zero-sum game.

A coin toss is a zero-sum game. If you and a buddy are flipping coins all night at $1,000 a toss, it’s just not possible that one of you will win more than the other of you will lose.

But now imagine that you are flipping these coins down at an all-night diner, and with each toss the waitress (or in this case, the broker) grabs $120—$30 from each of you when you call out “heads” or “tails,” initiating the bet, and another $30 from each of you when the coin lands and you settle up, closing out your position. That makes it “heads you win $940, tails you lose $1,060.”

But it’s worse than that. In addition to the commission, there’s also the “spread” between “bid” and “asked” when you go to buy, and later sell, an option. Say you were buying a December call on Chesapeake Oil at 70. It’s quoted “six to a half,” meaning you would pay $6.50 to buy the call ($650 for a single call on 100 shares) or get $6 ($600) if you were selling it. So there’s another 8% or so the house clips from your potential profit.

Combining commissions and spreads, maybe it’s “heads you win $860, tails you lose $1,140.”

How long would $4,000 last in an all-night coin-tossing contest like that?

But it’s worse than that, because in a theoretical coin toss, there are no taxes. With options, on the margin, the bite into your short-term capital gains from options trading may very easily amount to 40% or more of your winnings (especially if you live in a high-tax state). Yet losses are deductible against ordinary income only up to $3,000 a year. So if you made a $71,000 profit the first year and paid $25,000 of it in taxes, but then lost it the next year, you’d only get about $900 of that $25,000 “back” via the value of the allowable $3,000 tax deduction. Yes, you could carry the remainder of the loss forward. But how soon would you get to use it all?

So maybe now the game looks like, “Heads you win $550 [the $860 above, minus some taxes], tails you lose $900 [the $1,140 up above, minus some cushion from the tax loss].”

The exact numbers will vary all over the lot, but you get the idea. It’s a tough game to win.

Of course, if you actually knew which way a stock were heading, this would all be a quibble. If you knew a company were about to announce surprisingly good earnings, or a takeover bid, then there’d obviously be a load of money to be made in options. But it would be made with inside information, so it is not the kind of money YOU would make, for two reasons: (1) you don’t want to go to jail; (2) you don’t have information like this in the first place.

But some people do have inside information — and use it to trade options. That makes the odds for the rest of us even a little worse than described above, because the playing field isn’t entirely level.

So how is it possible someone could run $4,000 into $75,000? Well, if he happened to get interested in buying calls in a year when the market surprised most people by zooming 30%, instead of its more typical 6% (plus dividends, for an overall 9% or so), then he would have done extraordinarily well. (Someone buying puts or selling calls would have done extraordinarily badly.)

Having said all this, yes, I occasionally buy options. I made a killing on Merrill Lynch calls decades ago. They cost me 3/8 and were eventually worth 15 at expiration (although I had sold most of them on the way up). A couple of months ago I bought some Presstek puts when the stock was 150 and sold them when it fell to 65. But over the years, I’m pretty sure I’ve lost money with options.

If more and more people trade them, Wall Street will get richer but the nation won’t — any more than if we had 20 times as many casinos. Indeed, gambling for the sake of gambling, though it has entertainment value, saps resources from productive enterprise.

I’d suggest Jonathan continue to play the options market, despite the odds — but beginning fresh with just $4,000 each year. If he loses it, big deal. In light of a $71,000 profit, who cares? (And Uncle Sam will pick up part of the tab.) And if he keeps winning, that’s just one more reason for the rest of us to steer clear: he’s better at this than we are.

Monday: How He Did It

 

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