Understanding options trading and its similarity to gambling can help you avoid the hype and hold onto more of your money

A boom seems to be underway in newsletters that purport to show you how you can make money in options trading. These newsletters claim to have used digital technology to “crack the secret code” of success in the options market. They can point to a string of options trades they recommended that made money.

I suspect the only secret code they’ve cracked is the one that showed them how to use digital marketing to create a boom in options-focused newsletters, which once made up only a tiny part of investment publishing.

Understanding options trading can help save you money—mainly by staying out of it.

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Look beyond the marketing to understand options trading and its risk

Stock options are investment products that give you the right but not the obligation to buy a stock for a fixed price, within a fixed time period.

Buying stock options generates a lot of brokerage commissions, which is why some young, aggressive brokers recommend them for their clients.

In stock options, you’ll pay a higher-percentage commission on your outlay, perhaps 3% to 10%. Also, your stock options will have a limited life, expiring in a fixed period of weeks or months. Then you’ll pay another commission to replace them.

Stock-options trading is a great deal for brokers, because options investors pay much higher commissions than stock investors; they also pay commissions more frequently. That’s why options trading is generally a bad deal for investors.

Of course, a handful of options investors do make money—after all, somebody has to win the lottery. But on average, you just can’t make enough of a gross profit to pay the commission costs and leave yourself with any significant gains. That’s why most options investors wind up losing money.

Look at Las Vegas to get true insight on understanding options trading

The problem you have to overcome in options trading is the same one you face if you go to Las Vegas and try to make a living as a gambler.

To begin, the gambling casino—“the house”—takes a percentage out of every bet. Likewise, in options, you pay a commission every time you buy or sell.

Commissions are higher in options than in stocks, as a percentage of the sums you invest. In addition, options players pay commissions more often than stock investors, because actively traded options may only be weeks or months away from expiry. (You pay no commission when you hold options that are worthless when they expire. That’s a small consolation but a big drain on capital for most options players.)

Second, gamblers bet on essentially random outcomes, so you can’t acquire a significant edge over other players, especially in the short term. Likewise, option prices rise and fall in line with short-term stock-price moves, which are subject to a large random element. In addition, an option is a “wasting asset”; it loses value as it nears maturity.

Third, to the extent that it’s possible to build any edge over other players, the advantage will go to the hard-core gambling devotees who make a full-time job out of it. This, though, is an even bigger disadvantage for options players than gamblers. That’s because options players often wind up buying from or selling to options “market makers.” These market makers are not simply full-time gamblers; they are full-time, highly skilled professionals who are employees of or partners in options-brokerage firms. They don’t pay commissions in any real sense; instead, they share in the commissions that their firms receive.

Market makers trade both sides of the market—that is, they write new options contracts whenever they think they can profit by doing so. They don’t guess right every time, of course. They do guess right (or close enough) much more often than options players who are amateurs.

This new popularity in options trading is partly a generational thing. Many millennials (a general term for people born between 1981 and 1996) are less well-off financially than their parents were at their age. This is due to the timing of the 2007-2009 recession, and the weak employment opportunities that followed until recently.

As millennials begin building assets, they no doubt feel tempted to take on extra risk, in hopes of catching up financially with their parents or older siblings. I suspect many subscribers to options-trading newsletters are millennials.

In my experience, this kind of desperate attempt at reaching a missed financial goal often backfires. Rather than quick riches, it brings big, fast losses.

Bonus tip: Use our three-part Successful Investor approach to make better stock selections

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

How much more interested are millennials than their parents in options trading? Why?