Canadian stock options can generate a lot of money for your broker, but here’s seven ways they can cost you even more
Trading Canadian stock options can generate a lot of brokerage commissions, which is why some young, aggressive brokers recommend them for their clients. That’s despite increased trailer-fee disclosure and Canada’s full implementation of other disclosure requirements for the industry.
But with the increased competition brokers face in 2022 and beyond, those clinging to stock options may drop out of the investment business. Or they could choose another specialty. The truth is that it’s impossible to build a lasting clientele by trading options. That’s because they place their clients in investments that will almost certainly cause them to lose money.
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Here are 7 stock-option pitfalls investors continue to face in 2022:
High costs: You pay commissions each time you buy or sell stock options. Commissions eat up a large part of any stock option profits you make, particularly if you trade in small quantities. In addition, every trade costs you money in “slippage,” or the difference between the bid and the ask price. With options, this difference is wider than it is with stocks.
Limited room for error: Unlike common stocks, an option has a limited lifespan. You can hold common stocks indefinitely in the hope that their value may rise. A stockholder can wait out a temporary downturn in the hope of eventually realizing a profit. But every option has an expiration date. If an option is not sold or exercised prior to its expiration date, it expires and is worthless. For this reason, an option is considered a “wasting asset.” Part of the price you pay for an option is for “time.” As each day passes, you lose more and more of this “time” premium. To profit in Canadian stock options, you have to be right in three different ways: price direction, price-change magnitude, and time frame.
Direction: In order to make money with Canadian stock options, you have to be right about the direction of a stock’s price. If you buy a call option, you’re betting the price will rise. With a put option, you’re betting the price will fall.
Magnitude: Assuming you’re right about the direction of the stock price, you must also be able to predict the minimum amount that a stock will move. If the stock moves up or down by only a small amount before expiry, you’ll still lose money.
Time: The fact that options are valueless once they expire means an option holder must not only be right about the direction of both the price change in the underlying interest and the magnitude of the move, but also about when the price change will occur. If the price of the underlying interest does not go far enough in the anticipated direction before the option expires, the holder will lose all, or a big part of, the investment in the option.
No ownership rights: While stock ownership gives the holder a share of the company, voting rights and rights to dividends (if any), option owners participate only in the potential benefit of the stock’s price movement. (Note that when an underlying stock splits, the option contracts on that stock also split.)
Risk of total loss: Stocks can, and do, become worthless. But an option holder runs a much greater risk of losing the entire amount paid for the option in a relatively short period of time. This risk reflects the nature of an option as a wasting asset that is worthless once it expires. If the option holder doesn’t sell the option in the secondary market or exercise it prior to its expiration date, the holder loses the entire investment in the option.
How Canadian stock options 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. Options trade through stock exchanges, and each options contract is for 100 shares of a particular company. So one contract quoted at $5 will cost you $500 (before commissions).
Each contract has an expiration date, which gives it a limited life span (usually less than nine months). The strike price (or exercise price), is the price at which buyers can exercise their rights under the contract. There are two types of options:
Calls give the holder or buyer the right to buy the underlying security at a specified strike price until the expiration date. The seller of the call has the obligation to sell or deliver the underlying security at the strike price until the expiry date, if the option holder exercises the option.
Puts grant the holder or buyer the right to sell the underlying security at the strike price until the expiry date. In turn, the seller or writer of the put has the obligation to buy or take delivery of the underlying security until expiration, if the option holder exercises the option.
Instead of options, look to 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 Stock Pickers Digest newsletter.
Have you ever had stock options recommended to you? What was the main “selling feature”? If you decided not to buy, what was the reason? Let us know what you think.
This article was initially published in 2015 and is regularly updated.
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How true this is. A bit late for me to read your advice. I went throu the painfull experience of buying options and lose most all money invested (wasted literally).
One important fact not mentionned in your article, is that option sellers are big guys (market makers, large position holders in xyz stocks) playing around with small fish, (options buyers) teasing them to buy, and manipulating the markets to get their options sold, to lower values, and so on…. You see the trick, here.
DO NOT WASTE YOUR MONEY IN OPTIONS………
Stick to Mr. McKeough’s advice, better off with agressive investing….. no questions here!!!
Any NOK stockholder will tell you.
Buying naked calls is really a sucker’s game for all reasons advised. My own experience even in writing covered calls is that I missed out on a bigger increase, and if you write a covered option with a large gap to minimize getting called, the premium left isn’t worth the risk.
The other thing that options trading does is turn your investment mentality into being a trader, rather than an investor, which also compromises decisions on buying solid, dividend paying companies for quick hit speculative plays. At best, writing covered options may net an extra dividend payment over the year … Is the risk and effort worth half a percent of that position?
In options, you are betting against many elements and players in the securities house. No one is that good consistently.
It takes years to learn how to trade options. I have been trading them for about 7 years now (99% of the time US options). You can reach the point where you just do the one trade over and over again. It is very boring and very lucrative. The trade that I do returns about 7% return on risk. I am in the trade for about 16 days on average. Most successful option traders I know expect to double their money annually. Once again, it takes years of study to fully understand how to trade options.
Yes I agree. I have been looking at options for years, but the more I take in, the less I know. Do you know of any organization that has practice portfolios for option trading?
Thanks for your question. You might want to check out http://www.questrade.com. They offer practice accounts for Canadian investors.
Most amateurs enter option trading with a casino-customer mentality : strike it big and fast (need a good deal of luck to do that) and end up losing everything You have to study for years and then be patient and emotionless when you get into this field… Can you make money ? Definitely so but it is not for amateurs.
… and another point that is often forgotten. Even IF you write out of the money calls, and you get called on it, the tax implications unless inside a TFSA or RSP are substantial. So let’s say you wrote premiums for $500, then get called out on your position that has had CAP GAINS of $10,000. You either buy back your position, for a LOSS on the covered writing, OR you pay tax on the $10k gain. Few ever consider those ramifications.
I did this twice recently, thinking there is no way to get called. I’m now in the money, the option now costs 3 times what I sold it for, and I have 15 days for this to get back under the strike. My tax consequence is $5k if I do allow it to get called out, AND the commission it 1/3 the value of the total premium I received.
Pat … pls post this warning each month.
OPTIONS … the evil spawn of the investment (& taxation) world.
Thanks for the article. I agree that simply buying calls and puts can definitely lead to large losses, but you’ve only pushed your own agenda that you have the secret stock picks. If that was true, why wouldn’t I buy calls and puts on your picks to have that much more gains?
Using a long term investor mentality to options, by writing covered calls and puts on safe dividend aristocrats is the only way to assure gains in any market. Sure, you may ‘miss out’ on outsized gains but the trade off is you know how much you will make. No one should scoff at consistent 6-10% a year through dividends and safe option writing.
Don’t be greedy and go for the unicorns
Comments welcome and am open to being wrong
To Robert Hattin – isn’t paying taxes on gains still mean you made a gain?? What’s wrong with that
Thanks for your comment Matt.
Our long-standing advice is to invest in the “plain vanilla” securities: well-established companies spread out across the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities. Stay out of currency trading, penny stocks, new issues, options, futures or any high-risk investments. This way, while you may experience modest losses when markets drop, you should show overall positive results over time.
Options are like any tool – in the wrong hands they can do damage but used correctly can be beneficial. Get expert training, use a simulated account, and make sure you know what you are doing before trading your actual money.
Thanks for your opinion.
Gosh, yes, listen to Pat, because he knows best.