A Look at the Downsides of Option Investing

Most of the time, we talk about the wonderful aspects of investing in options. I am proud that the new strategy we set up five weeks ago has now had five consecutive weeks of gains (averaging over 5% a week), but today I would like to discuss some of the negatives in trading options.  Unfortunately, there are a few.

A Look at the Downsides of Option Investing

1.    Taxes.  Except in very rare circumstances, all gains are taxed as short-term capital gains.  This is essentially the same as ordinary income.  The rates are as high as your individual personal income tax rates. Because of this tax situation, we encourage subscribers to carry out option strategies in an IRA or other tax-deferred account, but this is not possible for everyone.  (Maybe you have some capital loss carry-forwards that you can use to offset the short-term capital gains made in your option trading).

2.    Commissions.  Compared to stock investing, commission rates for options, particularly for the Weekly options that we trade in many of our portfolios, are horrendously high.  It is not uncommon for commissions for a year to exceed 30% of the amount you have invested.  Because of this huge cost, all of our published results include all commissions.  Be wary of any newsletter that does not include commissions in their results – they are misleading you big time.

Speaking of commissions, if you become a Terry’s Tips subscriber, you may be eligible to pay only $1.25 for a single option trade at thinkorswim.  This low rate applies to all your option trading at thinkorswim, not merely those trades made mirroring our portfolios (or Auto-Trading).

3.    Wide Fluctuations in Portfolio Value.   Options are leveraged instruments.  Portfolio values typically experience wide swings in value in both directions.

One of our most popular portfolio (we call it the 10K Bear) has gained nearly 70% (after commissions, of course) in the last six months.  The underlying stock for the 10K Bear is the S&P 500 tracking stock, SPY, one of the most stable of all indexes.  Yet our weekly results included a loss of 34.7% in the last week of November when SPY rose $8.52 in a single week (a highly-unusual upside move).  Many times over the past six months, our weekly gains were above 20%, however, when SPY fell in value during the week.

Many people do not have the stomach for such volatility, just as some people are more concerned with the commissions they pay than they are with the bottom line results (both groups of people probably should not be trading options).

4.    Uncertainty of Gains. In carrying out our option strategies, we depend on risk profile graphs which show the expected gains or losses at the next options expiration at the various possible prices for the underlying.  We publish these graphs for each portfolio every week for subscribers and consult them hourly during the week.  

Oftentimes, when the options expire, the expected gains do not materialize.  The reason is usually because option prices (implied volatilities, VIX, – for those of you who are more familiar with how options work) fall.   (The risk profile graph software assumes that implied volatilities will remain unchanged.).   Of course, there are many weeks when VIX rises and we do better than the risk profile graph had projected.   But the bottom line is that there are times when the stock does exactly as you had hoped (usually, we like it best when it doesn’t do much of anything) and you still don’t make the gains you originally expected.

With all these negatives, is option investing worth the bother?  We think it is.  Where else is the chance of 50% or 100% annual gains a realistic possibility?  We believe that at least a small portion of many people’s investment portfolio should be in something that at least has the possibility of making extraordinary returns.

With CD’s and bonds yielding ridiculously low returns (and the stock market not really showing any gains for the past 4 years), the options alternative has become more attractive for many investors, in spite of all the problems we have outlined above.