Why Cheap Options are Sucker Bait: Traders Must Be Careful or Go Broke

Why so many state-sponsored lotteries? Are they sponsored out of some sense of charity? Is it that warm and fuzzy feeling that comes from seeing an average Joe randomly become a millionaire overnight? No. Lotteries are prevalent because they are cash cows for those who run them. People buy hundreds — even thousands of dollars worth of tickets every year, suspending their sense of reality by saying yes, but what if over and over again. They shell out hard earned cash to beat odds lower than being struck by lightning. The chance of winning any lottery has to be infinitesimal by definition – there is no financial incentive to sponsor a lottery unless more money is raked in than paid out. Market makers sell cheap options to the public for the same reason: to make money by taking the smart side of a dumb trade. Just because something is cheap doesn’t make it a good deal – ask anyone who owns a Yugo.

If bad trading is a sickness, then cheap options are an epidemic, and brokers across the country are doing their best to spread it like the plague. When the typical broker finds a client who?ll buy cheap options, the cash register rings in his head. The math is simple: the more options you buy, the more commission goes in your broker’s pocket. The cheaper the option, the more options can be crammed into your account – and the more commission dollars can be siphoned out. If a boiler room broker gets a $10,000 account to buy fifty calls at a hundred dollars each and charges a hundred dollar commission per option, that broker just put $5,000 of commission into his pocket. Half the account gone to commissions, just like that. Variations on this theme happen every day.

Brokers also love cheap options because once your account is loaded up with them, they can forget you exist. However, an account maxed out with futures positions may become a problem. It has to be watched carefully, not because the broker cares about the client, but because the broker doesn’t want to eat a loss if the futures move sharply and the account goes into deficit. But when a client is loaded up with cheap options, the exposure is limited. There is no risk of deficit. Until the options expire worthless and it’s time for another pitch, the client couldn?t matter less. Is it any wonder brokers pitch cheap options morning, noon and night?

Do cheap options ever pay off? Sure. even the super long shots come in every once in a while. But ironically, the trading public usually doesn’t collect, even on the rare occasions when they are right, because they lose it back again. Traders live and die by the law of averages. If the law of averages gives your method a positive expectation, then you have a chance of making money over the long run. (Note: if you have no method, you have no chance.) If the law of averages is against you, the best thing you can do is hope you?ll get lucky, and then take the money and run. You think most option players understand this? One would think so, since, these investors would certainly take their money and run if they won the lottery. They wouldn?t invest all their winnings in lottery tickets again. But, instead of taking their lucky gift, option players stick around long enough for the law of averages to take that money right back. They beat the odds on a hundred to one shot and think it’s the beginning of a hot streak – when that one score was the whole streak by itself, lock, stock and barrel. And, of course, when they win a round, their broker is right there with them, encouraging them to plow that windfall back into a bigger position. The process continues until the won money is given back and then some, leaving a poorer client, a richer broker, and a budding addiction to long shot thrills.

Many traders also prefer options rather than futures because they don’t like protective stops. They would prefer to buy options, hold them for a while and let them go to zero rather than bothering with setting risk points. This mindset is usually born of laziness or irrational fear of risk. Instead of using a proven risk management tool, the protective stop, these traders would rather pay a bundle in terms of time premium, basically flushing it down the toilet. These same options traders will consistently let the market take them out of the trade at expiration rather than taking direct action themselves. This passive loss taking can encourage a pattern of denial in which mounting losses are handled by avoiding phone calls and throwing away unopened statements – not exactly a recipe for success.

So what is the solution? Should you avoid trading options completely? Not necessarily. LEAPS Options can be effective trading vehicles if managed properly. But they need to be approached realistically, rather than in the dim haze of a gambler’s fantasy. There is no free lunch. Nobody is willing to sell dollar bills for fifty cents. No market maker will sell you an option without a hard-nosed assessment of what it is worth. Recognize that if your method does not suit the particular combination of advantages and drawbacks that options offer, then you should be sticking with more straightforward stocks or futures. And if you are one of those cheap option addicts looking for shortcuts and cheap thrills, you’d be better off playing the lottery.

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