What is Option Trading and Why is it All Over TikTok?
If you venture onto TikTok and search "finance", you will find a host of amateur investors telling Gen Z and young Millennials to stop partying, buying Yeezys, and surrounding themselves with negative people, and instead, start buying Tesla stock. The app is filled with best-case-scenario videos that remind their audience that if they had bought Blink stock (an electric car charging service) at the beginning of 2020, their money would have grown more than 2100%. Many of these gurus seem to have emerged in the wake of the first round of stimulus checks, or as they call them "stimmys" (ew), when young people suddenly found themselves with an excess of money and time. On the advice of these oracles of hindsight, they flocked to Robinhood and looked for fast-growing stocks that would turn them into the next Jordan Belfort. But even more concerning than the growing popularity of ill-informed share purchases is this group's heightened interest in option trading.
Before we continue, a quick lesson on option trading. Options are contracts that grant the holder the right but not the obligation to buy or sell a stock at an agreed-to price (called a strike price) on or before a particular date. It's kinda like an investment rain check, except you have to pay a premium for the rain check. A call option is the right to buy a stock and investors purchase these when they believe the stock price will rise. A put option is the right to sell, purchased when an investor believes the stock will fall. Each option contract represents the right to buy or sell 100 shares of a stock. The price of an option is calculated using mathematical models that incorporate a number of factors: time until expiration, the current stock price, intrinsic value, and volatility. Once you own an option contract, you have three choices: sell the option, exercise the option, or allow it to expire.
For example, at the end of July of 2020, Apple (AAPL) was trading around $93 a share. Let's say you bought a $93 call option with a 30-day expiration. You would have the right to buy 100 shares of Apple at $93 a share at any time in the next 30 days. Well, in August of 2020 the price of Apple rose to about $125 a share, so now you have a decision to make: you can sell the option contract for a nice profit, exercise the option and purchase 100 shares for a price now well-under market value, or allow your 30 days to run out in which case the contract becomes worthless.
Option trading initially rose to prominence in the 1970s, used by professional money managers as a hedging strategy to help reduce risk exposure. These managers would buy put options for stocks they owned but believed may be susceptible to price declines. This would allow them to unload the stock at a higher price and minimize losses. However, now option trading has become the get-rich-quick scheme of the social media age, coming to prominence in the smoldering hell-fire of the WallStreetBets subreddit and quickly spreading through TikTok and Discord servers. Shady online proponents of this style emphasize its ability to generate significant profit over a short period of time, often highlighting risky examples with small premium costs. In this way, young people are drawn in, viewing this form of trading as more accessible and exciting. With the prominence of commission-free, app-based trading platforms, most barriers to entry are removed. But their actions are starting to have a measurable impact.
In 2020, the daily volume of single-stock options was up 68% from the year prior. By December, volume was averaging a record 23.4 million contracts a day. Significantly, much of this activity came from individual investors buying and selling just a single contract and most of these were bullish call options with very short expiration dates and therefore lower premiums. The most popular stocks were also the ones you hear TikTok's finest consistently plug: Apple, Tesla, Advanced Micro Devices, NIO, and Microsoft. All of this reflects the reality that option trading is teetering dangerously close to becoming nothing more than gambling, with users' frenzied enthusiasm reminiscent of a casino floor. And just like in a casino, it's important to remember that the odds are stacked against these wannabe wolves, because what TikTok and Reddit fail to mention is that, on average, option buyers lose about 90% of the time. Remember, when you lose at option trading, you lose everything because the contracts have an expiration date.
This combination of high risk and lack of experience has become toxic, contributing to volatility and officials are starting to take notice. Robinhood is facing legal action at the hands of the Massachusetts Securities Division, which believes the app operates “without regard for the best interests of its customers”. The suit specifically cites the fact that the vast majority of users are approved to trade options despite little or no investment knowledge as proof of negligence. Hopefully, this will lead to permanent changes and help direct novices away from options. But for now, their popularity continues to rise, impacting the overall market and ruining many young people's finances.