People get into option trading for a number of reasons, but there are three primary motivations: to increase income, to protect positions, or to increase leverage.
To that point, a few articles caught my attention this week. The first was in the New York Times and discusses the perils of options trading, especially for the retail investor.
There is no question that option trading can be risky and that you can lose a lot of money if you're not sure what you are doing, in some cases even more than you have in your account. And there are brokers who push options for their own profit. TD Ameritrade is at the heart of the Times article, and I can safely say that options were the brokerage's focus even before the crisis in 2008 (as I worked for them at that time).
But options make good sense when they are understood correctly. Using options to increase income and/or hedge positions actually makes your account less risky, not more. It is true that such strategies will dampen returns in strong bull markets, however, so using small amounts to make leveraged directional bets can be a good way to aid returns.
The key is good option education , something we pride ourselves on offering here at optionMONSTER. I do find it funny that the article notes that "the brokers said they guarded against customer losses by allowing only wealthier and more experienced customers to proceed to more complex trading strategies." The irony is that the "more complex strategies" are usually less risky when used properly. I would take a vertical spread or a butterfly over an outright option purchase or sale almost any day.
The second set of articles involes a current tax proposal that could undercut the above strategies. From what I have read, the changes would greatly affect the taxation of strategies like covered calls and puts for hedging. It would make those strategies much less appealing to retail investors. At the same time, it seems that it would have no effect on the strategies that are most likely to see traders lose money.
Once again, education is key here. Understanding the big bad world of financial "derivatives," or at least of listed options, is necessary to make good choices--both for traders and for our government.
(A version of this article appeared in optionMONSTER's Advantage Point newsletter of May 29.)
More From optionMONSTER