By Victor Haghani and James White ¹

Judging by retail investor stock option trading volumes, the answer would seem to be an emphatic and resounding “YES!” For the first time since the introduction of listed equity options in 1973, the average daily notional trading volume of options on individual stocks has matched that of the underlying stocks themselves – at about $450 billion per day – with retail investors reckoned to account for about a quarter of this activity. On top of this is another $1 trillion per day in trading in options on stock indexes, plus further volume in non-exchange traded activity in structured products and exotic options.²

In our article just published in the Journal of Derivatives, written with our friend and Elm investor Vlad Ragulin, we ask whether options make sense for a broad class of investors. The Base-Case investor that we use throughout our analysis is risk-averse, with preferences modeled on a typical Elm investor – indeed, pretty close to those held by Vic, James and Vlad.³

Of course, one perspective on whether all this options trading makes sense is to argue that anything people do voluntarily must be in accord with their preferences and therefore is just fine. This has become a popular line of reasoning, but would have resulted in one of the shortest research articles ever.⁴ Instead, we take a less reductive approach, and start by defining what it means for options to “make sense” for our Base-Case investor. The use of options can have a complex impact on an investor’s portfolio – in practice, they can transform the expected return, risk and shape of the distributions of outcomes. As we’ve discussed in many previous articles, Expected Utility is the natural metric for making choices between different combinations of risk and return, and it can handle ranking arbitrary shapes of return distribution as well. So we’ll say that a particular options strategy warrants a place in an individual’s portfolio if it increases his Expected Utility.

Here are our main findings:

• Under classic textbook assumptions, fairly priced options don’t add Expected Utility, and therefore don’t make sense for our Base-Case investor.⁵
• If the investor cannot rebalance his portfolio frequently and/or the risky asset is prone to discontinuous price jumps or high transaction costs, then options can add Expected Utility by effectively replacing the continuous rebalancing that the investor is unable to do directly. However, the benefit from this use of options is very, very small in typical cases. This situation would most commonly call for selling a small amount of options, as that’s the correct options position for rebalancing an unlevered risky asset to a constant portfolio weight.
• When we relax the other textbook assumptions one by one, we find that fair options still don’t add much value for an investor who is willing to periodically rebalance his portfolio to account for changes in the investing environment, such as the return and risk profile of risky assets, and his current degree of risk-aversion.
• Turning to the use of far out-of-the-money put options as portfolio insurance, we compare buying insurance on your portfolio to buying insurance on your home. We conclude that if the probability of the risky part of your portfolio “burning to the ground” is at least as likely as your home going up in smoke, then buying options for protection might make sense, depending on how they are priced. However, it’s harder to know the true odds of a massive stock market decline than of estimating the risk to your house, and also in practice it’s difficult to buy portfolio protection that only covers a huge drop in value without also paying – and perhaps overpaying – for protection against smaller declines as well.
• At first it may seem strange to find a bad investment, like an options strategy which doesn’t add Expected Utility, and also find that the opposite of it is also bad. If we only consider the expected return, we can’t find such a case.⁶ But when we bring risk into the picture, and also require the investment to come in some quantum of size, then we can find many such cases. In the context of options strategies, we find that two popular and opposing strategies are both “bad” from a historical point of view, and are unlikely to make sense prospectively too, due to their both being very inefficient in the dimension of time-diversification. The two strategies are:
  • selling and rolling one-month put options on the stock market, keeping the rest of the portfolio in T-bills, and
  • buying and rolling one month put options on the stock market and keeping the balance of the portfolio invested in the stock market.
  The two strategies can be thought of as opposites in terms of their options exposure, and both have delivered a lower return and lower quality of return–in terms of Sharpe Ratio and maximum drawdowns – compared to a simple portfolio of 50% in stocks and 50% in T-bills over the past 30 years.
• Volatility should not be considered an asset class, as options are a zero-sum game. If it were an asset class, which side of the market would it be?
• The volatility skew⁷ is probably not something investors can materially benefit from. It’s devilishly difficult to determine the fair value for options, particularly for short-term and/or far out-of-the-money options.
• There’s an argument made that many young investors should use equity call options to have leveraged exposure that takes account of being in a state of low financial capital and high human capital.⁸ We’re not convinced there’s a big enough Expected Utility gain to make this strategy worthwhile in practice, but we accept that it’s plausible and in the right direction.
• When an investor trades an option on an individual stock, he engages in two zero-sum games at once: stock picking and options trading. Thus, any benefit would require either winning these zero-sum games or achieving a more efficient risk profile.
• Many investors view far out-of-the-money options as lottery tickets. For example, on many days in late 2021, Tesla options alone represented about one third of options volume, and about 80% of the Tesla options volume was on short-dated, far out-of-the-money call options. It may be that these options are a better deal, dollar for dollar, than a lottery ticket, but our Base-Case investor would be better off spending $10 a week on lottery tickets than spending $50,000 a year on far out-of-the-money options. Americans spend about $70 billion each year on lottery tickets. We think retail investors are spending multiples of that figure on options that are acting as a surrogate for lottery tickets or trips to Vegas.
• Investors should stay away from structured volatility notes, volatility ETFs, and exotic options.

While literally hundreds of books proffer instruction on how to make money trading options,⁹ there is not a single mention of options in many books on personal finance, including those written by such well-regarded experts as Jack Bogle, Charles Ellis, and Burton Malkiel. Our article is an attempt to bridge this gap, and in sum we find that options are unlikely to be welfare-enhancing, let alone a panacea, for individual investors with risk preferences similar to those of our Base-Case investor. This should not come as a surprise, given the zero-sum nature of the options market, in contrast to the generally recognized positive sum activity of investing in the broad stock market.

If you’re interested in diving more deeply into our analysis and conclusions on whether options warrant a place in individual investors’ portfolios, or more specifically whether they make sense in your personal circumstances, we’d love to hear from you.

1. This not is not an offer or solicitation to invest, nor should this be construed in any way as tax advice. Past returns are not indicative of future performance.
   
2. And all of this is just in the US, not counting non-US equity options volumes.
   
3. We assume the investor has CRRA utility with a standard risk-aversion coefficient. If such an investor is a utility-maximizer, then for bets with the same expected return and variance they will have a preference for positively-skewed bets (high chance of a small losee, low chance of a large gain) over negatively-skewed bets.
   
4. No article can beat Dennis Upper’s “The Unsuccessful Self-Treatment of a Case of ‘Writer’s Block'” in the Journal of Applied Behavioral Analysis (1974) which contained zero words!
   
5. The main assumptions are of a risky asset (or portfolio of assets) following geometric brownian motion, and an investor with CRRA Utility who is able to continuously rebalance without transactions costs.
   
6. Ignoring transactions costs and taxes. By Expected Return we mean the Expected Arithmetic (not compound) Return.
   
7. Low strike options trading at a much higher implied volatility than high strike options.
   
8. Most prominently by Ayres and Nalebuff in Lifecycle Investing: A New, Safe, and Audacious Way to Improve the Performance of Your Retirement Portfolio (2010).
   
9. Just type “options trading” into the Amazon.com search window.