Push for options helps brokers, not investors
As the sharemarket rises to new heights, E*Trade, TD Ameritrade and Charles Schwab are advertising the potential rewards of options, which give buyers the right to buy or sell stocks at predetermined prices in the future. Options, like their cousins futures, have traditionally been the domain of Wall Street traders. But the brokerage firms say futures and options can be profitable for ordinary investors too - a claim that, while true, does not square with many investors' actual experience.
While relatively little research has been done on the success ordinary investors have in trading options, analysis done for The New York Times by SigFig, a company that tracks 200,000 retail investors, showed that people who traded options last year received only about one-fifth the returns of people who did not trade options: 1.1 per cent compared with 5.1 per cent. The brokerage firms do not release data about customers' trading, and they are generally hesitant to detail the expansion of this business, but it has clearly been an area of growth. An analysis of scattered data from company filings and presentations indicates that derivatives trading, which includes options, has risen at all the major firms since the financial crisis of 2008, which left many Americans with big losses in their investment portfolios.
At TD Ameritrade, which has been the most aggressive, derivatives trades accounted for about 40 per cent of all customer trades last year - more than double what it was five years ago. A vast majority of those trades were in options.
The growth has been a help for online brokers at a time when share trading has fallen. The commission on the average options trade is more than twice that on the average stock trade, says TD Ameritrade's former treasurer, Michael Chochon. The results have been less of a clear victory for customers. Renaud Piccinini, who monitored customer accounts for TD Ameritrade before he left the company last year, said options could be used wisely in some circumstances. But he said he saw investors taking up options trading and "blowing up" on an almost daily basis. He said TD Ameritrade carefully tracked the risks its customers were taking but did not warn them until they were close to losing it all, if then.
"We knew that they were taking risky bets," Mr Piccinini said. "We knew inside the firm, but there was resistance to sharing that with the customer." Mr Piccinini is now working with Mr Chochon to create a program for retail investors that details the risks a prospective trade adds to a portfolio.
Steve Quirk, who oversees active traders at TD Ameritrade, said the former employees were criticising the company to generate interest for their firm.
Mr Quirk said TD Ameritrade gave investors a wide array of tools to gauge their risks, as well as significant education, before and after they started trading options.
"We hear from many, many clients that the more they understand about all the products that are available, the better equipped they are to deal with the market in any scenario," Mr Quirk said.
The companies began to push into this area after the financial crisis, with the purchase of smaller brokerage houses that focused on options. At E*Trade, filings indicate that options trades rose to 24 per cent of all trades last year from about 17 per cent in 2010. The total number of trades also increased.
Customers at all the brokers must take a number of steps before they are permitted to begin trading, and they must attest that they have read an official 186-page document laying out the risks of options. Almost anyone can go through this process, though.
Options typically represent the right to buy or sell 100 shares of a stock at some point in the future - allowing for a small initial investment that can lead to either big gains or big losses. Investors have bought in for a variety of reasons. Some believe they will be able to use the leveraged nature of options to supercharge their returns. Others see options as a way to insure their stock portfolios against future losses.
Academic research suggests, however, that on the whole, options traders do worse than share traders, who, in turn, have been shown in many studies to underperform buy-and-hold investors.
Frequently Asked Questions about this Article…
Share options give the buyer the right to buy or sell a stock at a predetermined price at some point in the future. An option contract typically represents 100 shares, so a relatively small initial outlay can produce large gains — or large losses. Because of this leverage, options are often riskier than buying shares outright.
Major online brokers highlighted in the article — E*Trade, TD Ameritrade and Charles Schwab — have been advertising options and expanding derivatives businesses since the financial crisis. E*Trade reported options rising to about 24% of trades from about 17% in 2010, and TD Ameritrade said derivatives made up roughly 40% of customer trades last year.
Research cited in the article (an analysis by SigFig) found that retail investors who traded options last year earned only about one-fifth the returns of those who did not trade options — roughly 1.1% versus 5.1%. Academic studies mentioned also suggest options traders generally underperform share traders, who themselves often trail buy-and-hold investors.
Brokers benefit because options and other derivatives generate higher commission revenue. The article quotes a former TD Ameritrade treasurer saying the average commission on an options trade is more than twice that of the average stock trade. Growing derivatives trading has helped online brokers while plain share trading has fallen.
Former TD Ameritrade account monitor Renaud Piccinini said he saw investors “blow up” on risky options trades frequently and that the firm tracked risky positions but was reluctant to warn customers until they were close to losing everything. The article also notes that academic research points to generally worse outcomes for options traders.
Customers at the brokers mentioned must complete several steps and attest that they have read a formal disclosure document outlining options risks — the article cites an official 186-page document. However, it also notes that almost anyone can complete the process and gain permission to trade options.
Yes — some investors use options as insurance to protect stock portfolios against future losses, which is one legitimate use of options. But the article cautions that, overall, many retail options traders underperform, so hedging strategies still require careful understanding and execution.
The article suggests caution: options are leveraged and can magnify losses, research shows many retail options traders do worse than non-options traders, and brokers have expanded options businesses because they’re profitable. It also notes brokers provide tools and education, and former employees are developing programs to help retail investors understand how a trade adds risk to a portfolio — so investors should use available education, understand risks fully, and proceed carefully.
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