How to Lose Billions Buying Stock Options

A week or two ago, I read a great article in The Economist and it was talking about a new form of gambling that seems to have taken hold in the United States, and it’s trading options just hours before they expire. As many of you already know, options can be bought 30, 60, 90 days, sometimes even longer out, and they become quite volatile in the last few hours of trading. In the graph below you can see just how much this activity has increased since all the GameStop traders started getting involved in the stock market post-COVID.

Increasing Option Action

In fact, in early 2020 before COVID really took hold, daily transaction volume was just 20 million transactions. It rose to 40 million in one year. This year, in February, we saw an average of 45 million options trades per day, and one day it peaked at 68 million so that’s a tripling of activity in just a few short years.

Are “Transaction-Free” Trades Really Free?

Where this increase in activity is going is what’s called zero days to expiration contracts, and they mainly traded on market indexes like the S&P 500, so they’re not even trading individual companies. There’s a big fundamental challenge with this kind of gambling, and it is gambling, and I’ll explain why. Options are a zero sum game minus transaction costs. The transaction costs, the brokers will tell you how this is a transaction-free trade. Yes, there’s no fee but there’s what’s called a bid ask spread. Anyone who does bonds or has bought a house knows what a bid-ask spread. It’s the spread between what the seller gets and what the buyer pays, and guess who gets the bid-ask spread. The broker, and the online brokers have been quite enthusiastic about this new revenue source.

The bid-ask spreads on options tend to be wider than most other financial instruments so the impact of these bid ask spreads is we take underlying stocks. If you look at the bell curve of returns for equities, the midpoint is positive and you would expect that. If you look at the bell curve for options though, being that they’re a zero sum game and that there’s transaction costs involved, even in the form of bid ask spread, the expected return is actually negative. Well, the only other place I know where the expected return is negative is Vegas and at least you can have fun, maybe even a stake, for your activities on Vegas. There’s actually a more subtle reason to be cognizant of this problem, and that is because even though this gambling activity is narrow and arguably none of my clients are doing it, there are a lot of people who engage in what’s called covered call writing.

Covered Call Writing

They’re basically writing options for a small fee so they can get more revenue from their portfolio, but what they’re doing is they’re trading upside for revenue, and that trade’s not a good trade. Not only is it taxable, sometimes quite unfavorably, but the same rules apply. It’s a zero sum game. The net return on options, even covered calls, is slightly negative. This is why we don’t write covered calls in portfolios, there are better ways to harvest income from a portfolio.

Better Ways to Generate Income From a Portfolio

One is synthetic dividends, two is regular dividends, interest income, you name it. There are all sorts of ways to harvest cash flow from a portfolio that beat the negative expected return that you get from covered calls. Why is it the fiduciaries don’t do it and brokers do? Well, as bid-ask spreads a revenue, money talks. In 2022, retail brokers made $2 billion off options trades. Just like in the casinos, the house always wins when you’re trading options but, unlike the casino, the brokers don’t provide free drinks. We wish you the best of investment success. Thank you.

Sources

“Retail Investors Are Losing Billions Buying Stock Options.” The Economist, The Economist Newspaper

Kenton, Will. “Zero-Sum Game Definition in Finance, with Example.” Investopedia, Investopedia, 15 Nov. 2022

Liberto, Daniel. “Zero Days to Expiration (0dte) Options and How They Work.” Investopedia, Investopedia

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