How does options trading work? Learn the ins and outs so you’ll know not just the promised returns, but also the hidden risks that will likely cost you money

How does options trading work? An option is a contract between a buyer and a seller that is based on an underlying security, usually a stock. The buyer pays the seller a fee, or premium, for certain rights to the stock. In exchange for the premium, the seller assumes certain obligations.

How does options trading work in relation to other investments?

Options fans say options are a great way to invest, because they limit your risk.

They say now is a particularly good time to buy calls (options that give you the right to buy a stock at a fixed price, for a fixed period), because you limit your losses to the cost of the option, but you get the same profit as you would if you owned the stock.

It’s true that they limit your risk. But they do an even better job of limiting your profits. Buying options has some essential differences from investing in stocks.

To start, you can hang on to your stocks as long as you wish, and sell only when you think it’s a good time to sell. That means you can hang on till the market has distributed the profits you hoped for. Options come with a fixed lifespan, usually lasting a few months. (Longer-term options cost a lot more.)

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The performance of any stock in a period of a few months is subject to a large random element, regardless of whether we are talking about Amazon, Alphabet or Lady Luck Mines. When you buy or sell an option, you aren’t investing. You are betting on an event (where the price will go in the short term) with a largely random outcome. It’s something like betting on a horse or a sports team.

Commissions as a percent of your investment are much higher in options than in stocks, even though the maximum holding period is “indefinitely” rather than a few months. The combination of high commissions and short lifespans virtually guarantees losses for outsiders.

Finally, and most important, options fans talk about options as if you could buy them at prices set by some bureaucratic, fairness-for-investors trading commission. In fact, the options market determines options prices, and options market-makers are the biggest influence on prices. They are the insiders.

Rather than get technical about it, let me explain market-makers by comparing them to bookmakers. Bookmakers (bookies) facilitate betting on horse races, sports events and other events with largely random outcomes. Options facilitate trading in options by “writing” them – that is agreeing to buy or sell the underlying security at the agreed-upon price and within the agreed-upon time.

Bookmakers don’t gamble. They take bets from gamblers, on both sides of the sporting events they cover, but at different odds, and they try to “balance their book”. That way, they aim to make money on each event, regardless of which horse or team is the winner. They usually succeed.

Options market makers do the same thing, but they do it with options.

Options or stocks. Which is best for your investor portfolio?

You can get lucky in options, just like anything else. But almost all non-professional options traders wind up losing money. Professional traders follow the options market minute by minute. When a true bargain appears, they jump on it.

To make money in options, you have to outguess other options-market participants by a large enough factor to pay commissions, which can be substantial. In the long run, options trading is what mathematicians refer to as a “negative-sum game”: one player’s gain is less than another’s loss, because their gain is minus commissions and other costs. In the end, the brokers end up with most of the money.

If you must trade options, do so as little as possible. And if you do trade options, trade them outside your RRSP. That’s because if you lose money on options in an RRSP you suffer a double loss. You also lose the tax-deduction value of a loss in your RRSP.

How does options trading work? Not as well as the aggressive stocks we recommend.

There’s a large element of risk in aggressive investments, but you can make money in them. In Canadian stock options, you will eventually lose. That’s the key difference between aggressive investing and stock option investing. If you want to invest aggressively, our best advice is to avoid options and buy stocks like those we recommend in our Power Growth Investor newsletter.

Stick with our three-part philosophy

You need to keep in mind that any long-term gain you make in the stock market comes from the profits of public companies you’ve invested in. We designed our three-pronged Successful Investor approach to tap into these profits. Here it is:

1. Invest mostly in high quality, dividend-paying stocks;
2. Diversify across most if not all of the five main economic sectors;
3. Avoid stocks in the broker/media limelight.

Many investors have found our system does a good job for them. Part of that is helping you spot “no-win” investment opportunities. That includes options trading.

How would you rate options in comparison to aggressive stocks? Do you think one or the other is a better investment?