Ask Stacy: Should I Invest in Stock Options?

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When it comes to life, we all have options. But when it comes to investing, should we invest with options?

That’s what this week’s question is about.

Hi Stacy,
I am an avid reader of the daily MoneyTalksNews articles, and I have learned so much from them. So, the first thing I want to say is THANK YOU for this wonderful outlet of information! Secondly, I have an idea for an article that I think will benefit and educate many: Stock Call and Pull Options.

I recently attended an online “Rich Dad, Poor Dad” webinar, where they discussed ways to make money on stocks in both bear and bull markets, and I found the information very interesting, yet confusing. Of course, at the end, they plug the $79 stock options class but, despite that, purchasing these types of options seemed to make sense.

I appreciate your straightforward approach to explaining everything money, so I thought you would be the best source to discuss this topic as well. I’m not sure if you already have an article like this, but I feel like I need just a bit more basic understanding before I take the leap and purchase some of my own, and someone else out there may be in the exact same position. Thanks for any help you can provide Stacy, and keep up the great work!
Veronica

Thanks for the kind words, Veronica!

I’ll begin with some unsolicited advice and a strictly personal opinion. I’m no fan of Robert Kiyosaki (the guy behind Rich Dad, Poor Dad). As far as I’m concerned, he’s one of many “gurus” out there who’s much more interested in lining his pockets than yours, and is one of many examples of people who earned their credibility not with credentials or experience, but by publishing books promising simple solutions to complex problems, then securing appearances on Oprah.

Now, let’s get to your question. As it happens, I have done stories on options, both in video and print. Following is a video I shot on the floor of the New York Stock Exchange several years ago. Check it out, then read on.

Understanding options

As we learned from the video above, a stock option is an investment that offers an investor the right (or “option”) to buy or sell an underlying stock at a specific price within a certain period of time. Basically, an option is a bet on the short term price movement of a stock.

If you want to bet on a stock going higher, you’d buy a “call” option. If you think the stock will drop, you’d buy a “put” option.

Why stocks work and stock options don’t

When you buy a stock, you’re buying into a company that you hope will become more valuable over time. Everyone who buys can theoretically win, because wealth is created. Example: If Apple sells 3 million iPhones in three days, Apple has more money than it had before, at least if it sold them at a profit. So everybody invested in Apple’s stock is a winner, and nobody lost. This is what’s known as a positive-sum game: one where nobody has to lose for someone to win.

Stock options, on the other hand, are a zero-sum game, because the only money you can make is money somebody else loses. In a zero-sum game, no wealth is being created. Instead, money is merely changing hands.

An easy to understand example of a zero sum game is the one I used in the video above: poker. When you play, the only money you can win is money other players lost. Wealth isn’t being created, it’s just moving from one side of the table to the other.

It’s the same with options, commodity futures, and other types of derivatives trading.

Putting money in positive sum games, where wealth can be created, is investing. Putting money in zero-sum games is gambling.

To make matters worse, options, futures, and casinos aren’t really zero-sum games. They’re actually negative-sum games. Because as you win money and the other players lose, the “house” is also taking some of each pot. So the pot of available money you can make is gradually reduced by “transaction costs.” In a casino, that’s known as the cut. On Wall Street, it’s known as commissions.

When to play a zero or negative-sum game

There’s nothing wrong with playing in a zero or negative-sum game as long as you’re either the best or luckiest player. That’s what the World Series of Poker is all about: finding out who that player is.

The same logic applies to options. Can you make a winning bet? Sure, if you’re either smart or lucky. When you sit down at the options table, you’ll be playing against some of the most sophisticated traders in the world. If you have inside information (which would be illegal) or you really feel you know more about a stock than the vast majority of professional investors, fine. Place your bets. But if you just have a “feeling” that a stock might go up soon, the bet you’re placing is no more intelligent than stuffing money into a slot machine.

I worked as a stock broker for 10 years. (Unlike Robert Kiyosaki, who, according to his Wikipedia page, never worked as a professional financial adviser.) Over that time, I speculated on options both personally and for dozens of my clients. While I had a few winners, over the long term I lost money and so did each and every client who tried it. Zero exceptions.

If you don’t believe this, conduct the following test. Call any accountant who does personal income taxes for a living. Ask them how many clients they’ve had over the years who consistently made money speculating on stock options. Let me know what they say.

Options as a hedge

As I said in the video above, options do have legitimate uses. For example, they can help hedge a portfolio. If you own Apple and think it’s going lower between now and next month, you could sell a call option and earn extra income. Or you can buy a put option that increases in value if Apple goes down, thus purchasing a kind of insurance policy against a price decline.

But these strategies are ways to gain extra income or protect the profit on stocks you already own. If you’re using options to speculate on stocks you don’t own, you’re cruising for a bruising.

The bottom line

There’s a lot of interest in options these days like shows on CNBC, and heavily advertised websites and trading platforms that can’t wait to convert you into an active trader of everything from options to foreign exchange contracts.

But while these companies attempt to paint a glamorous picture of what derivatives can do for you, remember this: I paid more to learn to avoid speculating with options than I did for four years of university. Seriously.

Of course, you could be smarter than me. I couldn’t make a living playing poker, but there are people who do. But even if you fancy yourself one of those people, there’s no reason to pay $80 for an options course. You can find an infinite amount of information online and at the library about stocks, options and every other type of investment.

And if you do decide to go forward, I’d urge you to play this game on paper for a long time before risking any of your hard-earned cash.

Have you had experiences with stock options you’d like to share? Please do so below or on our Facebook page.

Got a money-related question you’d like answered?

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The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

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