IN 2005, my wife and I attended two seminars on options trading - an investment tool anchored on the concept of leverage. Two of my friends attended the seminar and signed up for the course immediately. Today, one has stopped after huge losses and the other is still struggling to make a profit.
Having attended the seminars, I reckon the trainers did not give a balanced perspective on options. They focused only on the benefits:
Power of leverage - how one can make huge profits with little cash;
Concept of limited losses and unlimited gains; and
How to make profits in all market conditions.
It is difficult for investors to make huge profits with a low capital investment because of the way options are priced. The price of options is determined by the price of the underlying stocks, intrinsic value, time to expiry, volatility, interest rates and cash dividends. In layman's terms, low-priced options have a low positive price relationship with the underlying stocks. In other words, if you buy options for 10 cents and the price of the underlying stocks is $100, you will likely experience zero or minimum gain when the stocks advance.
How about limited losses and unlimited gains? In theory, if you pay only a fraction of the cost of the stocks, your risk is limited to the amount you invest. In reality, options have a limited lifespan - their value decreases towards the expiry date. Although your loss is limited to the amount you invest, you will experience frequent losses because options expire and decrease in value. Some may argue that you can restrict your losses by selling options before they expire. But the price may fall to a level where there is no demand.
Another benefit touted in options-trading seminars is the ability to make profits in all market conditions. To do that, you must predict market movements accurately. In other words, you must be able to unwind your positions and open new ones quickly, before market conditions change. All this must be done before the options expire. Does this sound possible? Will the stock market remain favourable before your options expire? The answer is no.
This article was first published in The Straits Times on May 13, 2008
