This week I read in the news the tragic story of a young trader who didn’t fully understand options trading before creating an account with Robinhood. According to the lawsuit the beginner trader incorrectly believed or possibly had miscommunicated to him, that an options trade that he had placed through the broker had led to a $730,000 loss, far beyond the potential loss of about $10,000 that he had initially accounted for as the worst case scenario. He tried to contact the broker on a number of occasions to clarify the situation but to no avail and, fearful of the impact such a huge loss would have on his parents’ finances, tragically took his own life.
Sadly, according to reports, in actuality the loss was covered by other options in his account. The parents of the unfortunate soul are now suing the broker as they feel he was not sufficiently educated by them to understand the potential ramifications of what he was doing.
This leads me to question whether enough is being done at the account opening process for those taking their first foray into trading. Although Robinhood does have an education section on their website, in reality, are young enthusiastic investors really going to take the time to read through it with care? When trading options in particular, there are so many nuances that could lead a trader to believe they are in a worse position than they exactly are.
Risk management is a vital skill for any trader. Understanding your downside risk really is the key to successful trading. This comes with both account management and trade management. When placing a trade it is not just prudent, but essential, to understand the maximum loss you could incur from any position. Professional traders in fact focus far more on the opportunity cost of a potential trade than the potential return. For example, if you think the S&P 500 will rise over the next month or so, how much are you willing to commit to test that theory? Understanding the risk/reward dynamics of trading is truly critical; not just to bringing in sustained profits but to avoid wiping out all the money in your account. This coupled with win ratios and probability can really make all the difference.
Options trading is slightly different. If you are buying options your downside is protected by the premium you pay. If you are selling options (puts/calls) the losses could, in theory, be limitless.
If you buy a call option you are betting that the market will move higher. There is also a time decay element that needs to be considered too.
If you buy a put option you believe the market will fall. Again, the time factor needs to be considered.
If you are selling puts then you are doing this in the hope that the market does not fall and you collect the premium but, crucially, with selling puts the time decay works in your favour.
If you are selling calls, you are hoping that the market moves lower and you collect the premium. Again, the time decay works in your favour.
The best way to explain time decay is with sports betting. If you have a bet that Man Utd are going to beat Tottenham but the score is 0-0 then the closer you get to the end of the game then the less likely it is that they will score. This causes your cash out (or the value of your bet) to fall as time keeps moving forward toward the end of the game. This is time decay in a nutshell. Options always have a time value; you can, for instance, buy daily, weekly, monthly (etc) expiries.
My hope is that in the future, education becomes more prevalent at the account opening stage. Money is an extremely emotional subject for many, especially at the beginning of any trading journey. That this young trader was not given the relevant education, communication or support before putting money on a trade had truly awful consequences and I for one strongly hope, whatever the legal outcome, that lessons from this can be learned by brokers in order to avoid repeating this terribly sad story.
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