Question of the Week: 12/7/2007

Most traders seem to lose money when they play options. Why ?


When tossing a coin, there are only two future outcomes - heads or tails. If allowed 1000's of tosses and guesses, the odds are you will "forecast" the outcome accurately 50% of the time. But, what happens to your odds if the number of tosses is limited to 100 or 10 or 1? Or, what if you allow the coin to be tossed only a certain period of time. Can the average person toss a coin once every 10 seconds, and what if you don't have an "average" person? Each additional variable begins to impact the future outcome and the accuracy of your guesses. The odds of 50% accuracy decrease as the number of tosses decline or the number of variables increase. The more complex a system, the more difficult it is to predict the future.

If you own stock in a large, multi-national corporation, you can theoretically hold that certificate forever. I have family members who inherited stock 50+ years ago and never sold it, even as the company went through mergers, buyouts, acquisitions, splits, etc. Unless a company goes bankrupt, there is no expiration date to the transaction. For Fortune 500 companies (and the like), if you wait long enough, inevitably the stock's value will increase with time and at a rate equal to or greater than inflation. This makes financial success in the stock market (given enough time) relatively easy compared to other paper investments, such as futures and options.

When you trade futures, all aspects of stock trading are present, plus two additional factors - leverage and timing. You can't hold a futures contract forever. When it expires, either you made or lost money. As a result, you not only need to be right about the direction of the market, but the expected move needs to occur by a certain date, which is typically no more than a few months in the future. That increases the complexity of the environment, thereby reducing your chances of success.

When you trade options, all aspects of stock and futures trading come into play, plus the added dimensions of volatility (beta, gamma, delta), the ability to buy or sell two vehicles (Puts or Calls) and the decision must be made of whether to enter them in-the-money or out-of-the-money. Finally, liquidity is an additional factor you rarely need to consider in larger markets. The number of variables involved in the options markets increases the complexity of the transaction to such a degree that the chances of accurately assessing market direction, magnitude, volatility, liquidity and timing are remote. My broker Byron tells me at least 80% of option BUYERS (i.e., those buying Puts or Calls) lose money. My other broker Jason says it another way, "Options are the only game in town where you can be right about the market's direction and still lose money."

Options constitute one of the most complex markets in the world, which is the reason so few are able to consistently make money trading them.

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