We all know the world of investing changed in 2020. Most notably, the process became more democratized as retail investors, individual or non-professional investors, entered the market to create a new source of income by participating in financial markets. Many chose platforms such as Robinhood as their primary trading method, and used social media as their primary source of information for choosing assets. As a result, many people became exposed to options trading; if you haven’t heard the term we’re about to dig in.
For those who aren’t familiar, options are a type of “derivative”, which in short means that it is an asset that retains its value from another asset (usually called an underlying asset). To make it make a bit more sense, let’s use sneakers as an example:
If you use Nike’s SNKRS app you a ticket which gives you the right to purchase a pair of sneakers. Under this example, the sneaker would be the stock, and the “option” would be the ticket you earned by using SNKRS. The ticket doesn’t give you the sneaker, but instead gives you the option to buy the sneaker. Due to the fact that the ticket gives you a right to purchase a sneaker, the ticket itself has value. This value of course is determined by the value of the sneaker. This is partially how options pricing works. There are other factors, but for the sake of time, we will move on.
Although options trading has increased in popularity, certain disclaimers are rarely discussed and should be aware to any retail investor. One disclaimer is the tax implications. Since options are not part of a traditional asset class, they are taxed under a different section of the IRS tax code. IRS Section 1256 classifies options as “contracts and straddles” which is separate from simply owning stock (which is subject to capital gains tax).
Under Section 1256, any short term gain (under one year) is taxed at 40%, and any long term gain (more than one year) is taxed at 60%. For context, if you traded options during a short term period and made $100 you would owe $40 to the IRS out of that $100. If you traded options during a long term period and made $100 you would owe the IRS $60 out of that $100. Although options can provide significant returns, you should also know that they come with a hefty tax bill and you should be prepared for that.
Another disclaimer that investors should be aware of is the ecosystem that makes options trading very profitable for brokerage platforms. Specifically, platforms such as Robinhood makes a significant amount of its revenue by selling options trades to high frequency trading firms (which is long for high-speed traders). In December of 2020, Robinhood earned 64 cents per options contract executed on its platform. This has been a profit center for them, and they have been incentivized to continue pushing for more options trades. In 2020 alone, Robinhood’s options trading activity has increased by 197%, the highest in the entire online brokerage industry.
Alongside these two disclaimers are the increased risk that options trading carries. Traditionally, options are used as a risk management strategy to limit your exposure to owning certain stock. Think of it as an insurance policy. You buy a car, but you also pay for insurance. Not because you hope to crash your car one day, but to make sure that you’re covered just in case you do crash your car. But as of late, many people have been trading options without owning any part of the stock which leaves many investors overexposed. Although it may be cheaper to enter an options trade without owning the stock, it also is much easier to risk losing all of the money you poured into that trade. This is because options are more volatile than stocks themselves. In fact, 2020-2021 stocks have been significantly more volatile than usual.
Of course, there’s a dopamine hit that resembles winning at the Blackjack table in Vegas when you win out on an options trade, but this isn’t traditionally how investing works. Investing is a wealth building process that takes time. It’s a learning game not a gambling one. It shouldn’t be left up to chance, everything needs to be cold and calculated. This is also why there should be more time spent doing investment research than actual trading. It’s also found that a significant majority of people who day trade actually lose money over time.
Whether is trading options, stocks, cryptocurrencies, or any other asset you should be sure to check for all of the disclaimers. You want to check to see that the primary profit driver isn’t you, but instead your financial success. Finally, you should be investing more and trading less, statistically it’s been proven to provide higher returns over time instead of trying to time the market.
That’s it for this week’s edition of The Dime. Don’t be stingy with this though, pass it to a friend.