Investor Toolkit: What stock options may reveal about a broker’s conflicts of interest

Stock Options

Today’s tip: “A healthy sense of skepticism can help investors avoid conflicts of interest—as,  for instance, when the prospect of higher commissions may prompt a broker to steer a client into stock options.”

Let me remind you of a couple of our most valuable Successful Investor rules:

First, a healthy sense of skepticism is your most valuable analytical tool.

Second, the greatest risk you face as an investor is to fall victim to a conflict of interest.

When I raise these two intertwined ideas, friends of mine who work as brokers sometimes say, “You must have an awful opinion of brokers, judging by the terrible things you say about us.”

That’s a misconception. Brokers are human. Some are people of high integrity; others, not quite so much. But the core of the problem is that the financial industry offers its salespeople incentives to give clients bad advice.

A broker can sell his or her clients a wide variety of products and services that will bring the broker a wide range of fees and commissions, from high to low. As a general rule, the more income a broker earns from selling a particular investment, the weaker the match between the investment and the interests of the client.

For example, suppose you tell your broker that you have some money and you want to invest it aggressively. He or she could suggest buying, say, some stock in Google. It’s a relatively young company in a fast-changing field, and it’s non-dividend-paying, so it’s somewhat aggressive as an investment. It has substantial profit potential, however, since it is the leader by far in a field with a lot of growth ahead.

If the broker advises you to buy Google, however, you’d only have to buy it once, and you might pay a commission of, say, 2% to 3% of the stock’s price. The broker is far better off financially if he advises you to try your luck in stock options. (These investment products give you the right but not the obligation to buy a stock for a fixed price, within a fixed time period.)


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The first thing that earns us referrals is a history of good results. But our clients also vouch for the way we conduct our business. We have eliminated conflict of interest. Clients can expect unbiased recommendations for their portfolios, without hidden costs or commissions.

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Frequency and cost make stock option trading a great deal for brokers

In stock options, you’d pay a higher percentage commission on your outlay, perhaps 3% to 10%. Also, your stock options would have a limited life—they would expire in a fixed period of weeks or months. Then you would pay another commission to replace them.

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

Of course, a handful of options players 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 players wind up losing money.

You’ll find lots of conflicts of interest in the investment/financial business. Some are less costly than options trading.

For instance, brokerage firms sometimes accommodate institutional clients by buying blocks of stock from them, when it might otherwise take days or weeks for the institution to sell the stock on the market at a favourable price. The brokerage firm then takes the stock into inventory and offers its brokers an extra fee or some other inducement to sell it to their own “retail” clients.

Respectable brokers only do this with respectable stocks, of course. But the opportunity to earn an extra fee and win favour with the boss can lead some brokers to make recommendations that are more for the broker’s benefit than the client’s.

It’s hard for a broker to settle these conflicts in the investor’s favour and still make a good living. However, brokers have no legal obligation to settle conflicts of interest in the clients’ favour. By law, they only need to ensure that investments they sell are “suitable” for a client. Stock options generally qualify as suitable for a client who wants to invest aggressively and who can afford to absorb the inevitable losses.

Overall, investors lose more money to conflicts of interest than to any other single risk. That’s not a comment about the average broker’s sense of ethics. It’s simply a matter of frequency of exposure times risk per exposure, coupled with the low standard presented by the suitability rule.

So maintain a healthy sense of skepticism. Learn to distinguish between fact and opinion. Watch out for opinion that’s tainted by conflicts of interest. You don’t need to settle for investments that are merely “suitable” for you. Hold out for investments that are in your best interest.

The difference may seem subtle on the day you buy. But learning to tell the two apart will make a huge improvement in your long-term investment results.

Comments

  • Steve V.

    My experience is that the buying of puts and calls is often a losing game. However, there are some options strategies that can be consistently profitable. Covered calls and cash secured puts are two that often work because someone else is paying for the time decay. But neither strategy is without opportunity cost or significant risk and should be entered into carefully.

    Even if one never trades options, a basic understanding of these vehicles can add to ones knowledge about the market.

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