While this might be an internet banner ad or a spam email, it’s also actually possible! You could start with a handful of dollars and earn millions with a few investment trades. There’s a catch though...
Actually there are two catches, but keep reading because these can teach us about general investing…
Catch #1: Somebody else will have to lose about $8,500,000.
Catch #2: You will need a crystal ball to tell the future.
Earning millions with small amounts of upfront money is theoretically possible in the derivatives market. Derivatives are financial instruments that “ride on top of” other financial instruments. Examples of derivatives are stock options and futures. If you can somehow predict the future, legally, better than the rest of the market, then sure enough, you can make a fortune using derivatives.
Derivatives are used mostly by institutional investors to hedge positions and reduce risk – think of an honest farmer willing to pay a fee now for an option to sell next year’s harvest at a fixed price. But the derivatives market can also be used to make “naked” trades by participants who have no interest in the underlying stock or commodity. This is essentially like playing roulette.
So how to earn $8,500,000: Imagine you know the price of stock for a particular company is going to jump next month from $100 to $150. You could buy one stock and earn $50. A 50% return – not bad!
You could buy an option to buy one stock at a point in the future for $105… say this option costs you $1. If you had $100 to invest you could buy 100 of these options. When the underlying stock goes up (as predicted by your crystal ball) and can be sold for $150 each, you would execute all 100 options (e.g. simultaneously buy 100 shares for $105 each, and sell each for $150) so each option would be worth $45, and WOW your $100 position has gained $4,400, a 4,400% return! Now simply repeat this maneuver with two more similar type trades, using all your $4,400 gains from the 1st go-around and you’ll suddenly have around $8,500,000 – not bad at all.
Sounds great! So why don’t I recommend these strategies (or even some altered form thereof) to my clients – in addition to my reluctance to ask anyone to “go naked”? Two reasons:
The derivatives market is a side show. It’s not the main event. In the main event of investing investors get paid interest or dividends, and/or their investment grow (capital gains). The consensus expected return of an investment is always positive (otherwise no one would invest). So there’s net gain.
By contrast, the derivatives market is a ‘fixed pie’ since every dollar won is actually someone else’s loss. Repeated options trading will tend to revert to a lifetime average of zero (before trading costs & fees, of course).
The absence of real-life investors who have magically turned $100 into $8,500,000 teaches us an interesting lesson about market efficiency. The next time you hear someone with a loud opinion about the future of a particular market you could ask “how many naked option positions do you hold supporting that”. You’ll likely get a blank stare in reply, but the point is that nothing is a sure bet. Public markets offer a consensus on expected return and risk but no one knows exactly what is going to happen in the future. If we could, we’d all be heading for the Roulette table.
So yes… it’s possible to earn millions in the derivatives markets but please don’t try. Unless you have a crystal ball, your money should keep its clothes on.
Written by Ian Collings