How to Avoid Losing Grandma's Life Savings

It's a mistake that has destroyed the finances of too many novice investors...

WallStreetBets is a now-infamous Reddit forum. The community has become notorious for encouraging risky trades – and for fueling the "meme stock" mania.

Folks take to the forum to share opinions, insults, and memes. They also report their successes... and failures.

Those failures can be catastrophic.

One user inherited $200,000 from his grandmother before she passed away. It was the kind of nest egg that can give a huge edge to an investor just starting out. But soon enough, well...

This trader lost all the money. When one commentor asked, "Where's the rest of it?" he replied, "I lost it in SPY and TSLA calls."

Worse – he isn't unique. The pandemic minted millions of new investors, and many of them have fallen into the same trap...

It all started with Robinhood...

Robinhood is a trading app that targets small investors. And it had a great strategy for getting people to use it...

The company revolutionized the way folks invest by letting users trade right from their smartphones. Plus, it did away with commission fees.

The app launched in 2015. But it really took off during the pandemic. When COVID-19 hit the U.S. in 2020, Robinhood investors suddenly had a lot of time on their hands... and a lot of cheap stocks to buy with their extra cash.

Then, WallStreetBets kicked off the famous GameStop (GME) short squeeze. Trading volume reached an all-time high... And investing became a national obsession.

The app went viral for a dangerous reason... It makes trading really fun.

You can see it by comparing the app's "Discover Options" tab with the options screen of any competing platform. We'll use TD Ameritrade's e-trading platform, thinkorswim. Take a look...

You can see what it's like to buy options across these two platforms. They couldn't be more different...

Robinhood strips away the data. It favors a clean design. And above all, it's easy to use.

Naturally, that meant one thing... Quarantined small-time traders bought risky options in droves. After all, anyone could do it. For many new options traders, it seemed like a great way to level the playing field.

Call contracts hit a monthly record of 87.3 million in January 2021. Now, used the right way, options can be a great tool for traders... But that's not what these folks were doing.

Options can also let you make "all or nothing" bets on a stock. If an option goes your way, it's a big payday. But if it goes bad, you likely lose your entire investment.

This leads to hard lessons like the one in our opening story. The truth is... Trading is difficult. And "tuition" is expensive...

Researchers at the London Business School released a study this month. They found that small-time investors lost more than $1.1 billion in options trades between November 2019 and June 2021. And that's before losing an additional $4.1 billion in trading costs. (While trading stocks doesn't come with a fee, options contracts still do.)

The most popular strategy was buying ultra-short-term, out-of-the-money calls. Without getting too deep in the weeds, this kind of trade lets you "pick a winner." If it works, you get a soaring stock at a fraction of its spot price. But the odds of your trade working out are tiny... It's almost worse than gambling.

Sure enough, this strategy was the biggest loser in the study. And it made up 50% of all trades in the sample.

Just because an app is easy to use doesn't mean it's good for the investor. Robinhood made investing into a "game." And that has led to massive losses.

If you or someone you know is thinking about starting out in the market – especially options – take this rule to heart... Always start with a very small amount of money in your account.

The "right" starting amount depends on your personal finances. But as a general rule of thumb, let's say $5,000. That way, when you hit those bumps in the road, it won't cost you Grandma's life savings.

You can earn your stripes in the market without risking annihilation... And you can always up your dollar amount as you get better.

Don't fall for the "fun" before you've done your research. And please, please, please... start small.

Good investing,

Sean Michael Cummings

Further Reading

"If you think people are being irrational now... just wait," Steve writes. Robinhood has allowed a new generation of investors to enter the market. But if they let greed drive their decisions and only chase fast money, they could suffer huge losses... Learn more here: A New Band of Traders Is Flooding Into the Market.

"There is easy money to be made when the person you are betting against has no idea what he is doing," Jeff Havenstein says. And we're seeing plenty of young, inexperienced investors in the market right now who are seeking a quick payout. But it's critical to remind yourself to avoid the pitfalls of fast money... Read more here.

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Many new investors who entered the market during the pandemic got burned buying call options. But there's a smarter, safer way to trade options...

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