Why This Popular Trading Strategy Is So Risky - YouTube

Big rally on Wall Street at this hour.

Check it out. A historic day for the market.

The pandemic era stock market was filled with massive rallies.

Nothing seems to get in the way of the stock market going higher for very long.

And that drove a horde of investors to buy it, hoping to make big money.

A record number of new and novice retail investors jumped into the stock market over the

past two years. They were trying to figure out as they went and many of them dabbled

into some of the riskier trading strategies.

One of those risky strategies is called options trading.

An option is a contract to buy or sell an asset at a future date for a set

price. Options activity hit a record high in 2021, with nearly

9.9 billion contracts traded.

That was more than 32% higher than the previous record set in 2020.

Options are the kinds of bets where you can lose everything.

You're on social media, seeing more and more people talking about these amazing

gains that they've gotten.

It's not as easy as social media makes it sound.

The appeal for a lot of the retail investors to buy options is that they're much

cheaper, but your potential for profit is actually not that high.

Everything that you can trade options, futures, whatever they in and of themselves are not bad

tools. Fire is a wonderful tool.

If you don't know how to use it, it's going to end poorly.

So what we've seen with the rise of certain fintech apps like for example, Robinhood, it's

become increasingly easy for individuals to trade options.

It's actually a fairly unregulated area.

That's part of the problem.

So why did options activity increase so rapidly in the past year?

And what makes trading options so risky?

The whole meme stock phenomenon partly triggered the boom in options trading

among retail investors.

We're talking about stocks like GameStop and AMC that were popularized

on social media by retail investors trying to coordinate trades

and squeeze out hedge funds and other short sellers.

One trend that we've been seeing in options over the last year or two is a real focus

on the near term options 1-2 weeks out.

That's where we're seeing a higher percentage of the overall volume.

Individuals have often taken to social media to report their gains and

profits from highly successful options bets.

And that's made it very attractive for first time traders and those who maybe have invested

in more traditional, conventional ways in the past and are now interested in trying something new.

Technology has made trading options much more accessible.

Options have become increasingly popular among individual investors

using platforms like Robinhood because they can often yield profits

many more multiples of one's initial investment, when you might only be making

5% or 10% on your capital when you buy stock, with an option, you can make many,

many times your initial investment.

Think back to 10 years ago or 20 years ago.

If you wanted to trade an option, you needed to maybe call up a broker

on the phone.

You need it to pay a significantly high amount of commission.

You didn't see the markets real time.

There's much easier access to options markets and the use of

options has pretty much just grown alongside of that.

What some of these apps have done is made it a lot more visual to understand what your

profits and maybe even losses are going to be.

So that's led to an increased interest in trading options.

There's also a sort of addictive component to trading with highly

speculative instruments like options.

When you make a lot of money, maybe you just get lucky and you make a lot of money.

You're inclined to do it again.

This is in many ways like casino gambling.

People say, take the emotion out of trading.

It's very difficult to take the emotion out because it's money.

People get emotional about money.

What you want to do is make it as robotic as

possible, so you take that out of it.

How do you do that?

By driving appropriate risk on your investments

so that they're not eating you up inside.

Most popular trading apps generate a lot of revenue from payment for

order flow, and they can make more money from options than regular stock

trading. So there is an incentive for them to lure investors

into options trading.

I think there's a myth that's carried over from the 1970s where

firms just want to churn people up, etc.

No, we don't.

It's a bad use of our time.

It's a bad use of your time.

It's why we start everything we talk about in trading and investing

with risk risk risk.

Options are financial instruments which give you the

right to buy or sell a security.

They are called a derivative because they're a kind of financial

contract that's not a share of stock itself, but it's linked to or

derived from a share of stock.

It's best to think of options as an insurance product, and it's an

insurance product for stocks.

And options Contract allows an investor to pay a fixed sum of money to lock in a set price, to either buy

or sell an asset.

The underlying asset can be a stock, crypto, a commodity or a whole number of other

things. There are also two types of options contracts, a call and a put.

A call option allows the investor to buy, say, a stock at a pre-agreed upon

price. This price is called the strike price.

A put option allows the investor to sell at that strike price.

That means investors use a call option when they think the price of the stock is going to go up.

They use a put option when they think the price is going to go down.

We always used to say with old phones that used to sit down, you would call someone up, you pick up,

you'd call up, and when you put it down, you put down.

So the way to think about it is when you buy a call, you'd like us to go up, would you buy a point you'd like us to

go down.

Options can yield a high profit when exercised strategically, but miscalculating can come

with a big downside.

One of the risks of this sort of intense options trading is that people might

find themselves on the wrong side.

So it's great if you buy a call option and the price goes up, you'll make a lot of money on that

call option. But if you buy a call option because other people said that they bought call options

and the price ends up going down, well, that's where you can lose all your money.

Most popular brokers have a tier system for options trading, and they grant

access to their clients based on their income, their risk profile

and their trading experience.

Most retail investors only have access to the most basic call and

put options.

They don't have access to option spread or other more sophisticated

strategies.

Option spreads are used to bet against various market outcomes.

An option spread calls for buying and selling different contracts

at the same time.

It's a very common way for investors to hedge risk and volatility

and is usually cheaper because you can offset your cost by the proceeds from

different contracts.

And it's been used by Wall Street professionals for decades.

In 2021, 11% of Robinhood's active users

made an options trade, and of that, fewer than 1% actually made

a multi leg options trade.

Let's say a level one investor pays $30 to buy a simple Tesla call.

The stock strike price, which is the price the investor is willing to pay for the stock in the future, is

$1,000. In order for that trader to break even, the stock price has to hit at

least $1,030 before the call option expires.

The same goes for a level two investor.

A level three investor, though, has access to a more sophisticated strategy, a bull call

spread. With this strategy, the level three trader buys a $925 call

for a cheaper premium of $27.

The investor would also sell a $1,000 call.

At the same time, both of the call options would have the same expiration date this trader would

break even if the stock price hits $952.

This represents the bottom of their profit range.

They will continue to make a profit until the stock hits $1,000, which is the strike price of the higher

call option they sold.

This creates a range in which the investor can make profit.

This strategy is typically used when the investor expects a modest growth in the stock's price.

The level one investor has a 25% chance of profit, while the level three investor has a

40% chance.

So in the beginning, retail investors have to learn options trading by

trial and error because they don't have access to those more

sophisticated strategies at first.

And they will only be able to hedge risk and trade more complex

strategies with higher chance of profits later on when they graduate

to a higher level.

I've worked on a Thinkorswim platform for the last 16 years and we're very proud of it.

Our clients have more information now than most professionals did, and even 5-10

years ago. That's been fairly leveled, that part of the playing field.

The difference is what people do with the information and how

people put the risk of the trade on themselves.

In June 2020, Robinhood made multiple changes to its platform after a 20 year old

customer died by suicide and cited major losses on the app trading options as one of his

stressors. Those changes included making it more difficult to access Robinhood's options

offerings by requiring customers to go through specific education and to meet other criteria

if they are seeking level three options.

So we classically had for many, many years screening criteria

which are designed to filter investors by sophistication.

This is a difficult problem because whatever criteria we might invent

ends up inevitably being perceived as elitist or classist in some way that you

are excluding people who may not have had a particular form of education or may not have a particular

level of income.

And so the goal has been to develop screening criteria which are

neutral with respect to characteristics of people's background that may

unfairly discriminate.

So that's been a real challenge.

We don't want to lock people out of gains just to protect them from losses.

Regulators want to protect retail investors because they're aware of the risks

involved in options trading.

The irony is that now retail investors are less likely to make

money from options because of the lack of access to more sophisticated

strategies.

A Robinhood spokesperson told CNBC "Democratizing finance for all means

expanding access to important financial tools that were previously available only to the wealthy

few. And we're proud to provide an options experience that's intuitive, educational and

affordable with no contract fees.

We know options aren't for everyone.

Robinhood does not allow short selling or uncovered options trading." Beyond regulating

brokerages. There have also been proposals surrounding disclosure rules and social media.

We saw, for example, in the GameStop episode that certain market participants

were on social media saying, I bought hundreds of call options.

I've made millions of dollars of profits.

Other market participants began to mimic them.

And so that's actually not illegal right now.

Roaring Kitty was one of the influential figures

on Wallstreetbets subreddit.

He was consistently posting screenshots of his portfolio touting

massive profits from his GameStop position, and he was buying a bunch

of GameStop call options.

Roaring Kitty, whose real name is Keith Gill, testified in front of Congress in February

2021 about his intentions for disclosing his positions.

The idea that I use social media to promote GameStop stock to unwitting investors and

influence the market is preposterous.

My post did not cause the movement of billions of dollars into GameStop shares.

It is tragic that some people lost money, and my heart goes out to them.

In February 2022, the Securities and Exchange Commission proposed a new rule that would

tell investors more about short sales.

It would require certain investment managers to report short sale related information to the commission on a

monthly basis. The SEC would then make the aggregate data available to the public

for each individual security.

What we worry about are situations where people are saying one thing but doing something else.

So you might buy a call option thinking the rest of the market is genuinely bullish on a company.

But you were deceived because they were just telling you that so that they could cash out, or they could make

money, take your money, basically.

Sell while you were buying.

So the situation where people are saying one thing but doing something else, that's a real problem with

social media.

We wanted to get people to come to the market.

We didn't think that all come at once.

So I think that that was a bit of a surprise for all of us.

That said, the unheralded story is our

education usage went up in direct proportion to how many new clients we get.

People want to understand.

We want to give them the information, something our firm does.

And I think as an industry we do well, is give people just tons of

free education.

Invest in you.

Ready, set, grow CNBC and acorns.