Tuesday, May 28, 2013

Options? Subprime wasn't enough for you?

Do you have the same reaction as I when you read this New York Times article?  Excerpts:

Some of the brokerage firms that helped pique Americans' interest in stocks are now luring them into something much riskier: stock options. 

As the stock market soars to new heights, E*Trade, Ameritrade and Charles Schwab are advertising the potential rewards of options, which give buyers the right to buy or sell stocks at predetermined prices in the future. Options, like their cousins, futures, have traditionally been the domain of Wall Street traders. But the brokerage firms say futures and options can be profitable for ordinary investors, too — a claim that, while true, does not square with many investors’ actual experience.

Options?  Come on.  Most individual investors don't even know how to pick individual stocks, much less try to determine potential future valuations that would justify options.  The chance of financial disaster is high.  The article continues:

Analysis done for The New York Times by SigFig, a company that tracks 200,000 retail investors, showed that people who traded options last year received only about one-fifth the returns of people who did not trade options: 1.1 percent compared to 5.1 percent. 

All this is driven by greed, of course.

[E]xpansion of this business . . . has clearly been an area of growth. An analysis of scattered data from company filings and presentations indicates that derivatives trading, which includes options, has risen at all the major firms since the financial crisis of 2008, which left many Americans with big losses in their investment portfolios. 

At Ameritrade, which has been the most aggressive, derivatives trades accounted for about 40 percent of all customer trades last year — more than double what it was just five years ago. A vast majority of those trades were in options. 

The growth has been a big help for the online brokers at a time when stock trading has fallen. The commission on the average options trade is more than twice that on the average stock trade.

When a friend saw the Times article, she wrote me, "Aha! You have just explained why my assigned Ameritrade 'advisor' keeps bugging me and specifically suggested options a while ago. I know enough to know that's not for me."

But others are not so wary.  How can this be happening in an era of greater consumer protection in financial markets?  Well, that protection has not been forthcoming.  CNBC explains:

Dodd-Frank authorized the SEC to impose a fiduciary standard on brokers. But the agency, swamped with other rule-making related to the act, has so far done little. 

Under such a standard, hundreds of thousands of brokers would be legally obligated to act in their clients' best interests when recommending investment products. The most important change for consumers is that they would have greater legal standing to sue in cases where they had evidence they had been wronged.

At the moment, brokers (including people working for big Wall Street firms), small locally owned brokerages and insurers are obliged only to recommend "suitable" products. 

The new SEC chairperson wants to fix this, but look who is lining up against her:

Various interest groups are hardening their stands. The most powerful player is the Securities Industry and Financial Markets Association (SIFMA), which represents broker-dealers, including the big financial firms, such as Bank of America, Merrill Lynch and Charles Schwab. The stakes in an industry upheaval are big: According to Boston-based Aite Group, about 450,000 people give consumers financial advice; 45,000 to 50,000 of them work as registered investment advisors (RIAs) , and the rest operate under the aegis of broker-dealers. 

Until and unless the government acts, caveat emptor--and the seller, too, when it comes to options.


Paul V said...

So, Paul, you want the same government that sells lottery tickets to step in and prevent willing sellers and buyers from trading in options?

Paul Levy said...

Not prevent. Ensure salespeople inform them of the odds and advise them of the wisdom within their investment goals.

Anonymous said...

Paul - It's a misconception that options are inherently risky. Depending on how they are structured, they can be insanely risky or they can be much safer than buying a stock.

Typically they are bought in conjunction with each other(or the underlying stock) to establish a particular risk profile that fits the needs of the buyer. You might be interested to know that as a Schwab client I had to be authorized to do anything other than the most conservative options trading (covered calls.) I had to demonstrate to Schwab that I had the experience and competence to assemble positions appropriate to my particular goals.

IMO, All investing should be done after doing the appropriate research. If you don't have time, either stick with index funds or hire the services of an independent financial adviser

Paul Levy said...

Good points all.

Paul V said...

I'm glad to see that you are not advocating a government prohibition, just a requirement to "inform and advise," but this still makes me squirm. Who is the judge of what is a "wise" investment? Studies also show that 3/4 of actively managed mutual funds do worse over time than passive index funds, should we require financial firms to advise and inform customers of this? I'm with you on the caveat emptor advice, but I hope that government does not step into this.

Anonymous said...

Paul V, as the friend in Paul's post whose Ameritrade advisor tried to get me into options, I think there is a line between allowing people to do stupid things on their own, and giving outright misleading advice. One analogy in health care might be pharma companies promoting off label uses of their drugs - while it is legal for the doc to prescribe them, the companies are not allowed to promote them. So, while options might be available for those who know (or think they know) how to use them, I don't think brokers should have carte blanche to lead unsuspecting clients down the primrose path. In my case, I had told the advisor I was recently divorced and inexperienced in handling stocks. Instead of taking extra care with me, he instead saw a 'mark' to be exploited.

Mitch said...

You are spot-on regarding options. I like the saying "Financial engineering means your money becomes their income."

Absent the DNA of Warren Buffet, index funds win.