Ask Stacy: Should I Invest in Stock Options?

Photo (cc) by Images_of_Money

When it comes to life, options are a good thing. But when it comes to investing, is it good to put money into options?

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

Hi Stacy,
I have an idea for an article that I think will benefit and educate many: Stock call and put 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. 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” who’s much more interested in lining his pockets than yours. He’s one of those people, unfortunately one of many, who promises magical solutions to complex problems instead of relying on expertise that comes with credentials and experience.

In short, not only would I not buy anything from this guy, I wouldn’t listen to a thing he has to say.

Now, let’s get to your question.

Understanding options

A stock option is an investment that offers an investor the right (or “option”) to buy or sell a stock at a specific price within a certain period of time. So an option is basically just a bet on the short-term price movement of a stock.

If you want to bet a stock will go up, you’d buy a “call” option. If you think a 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 a share of a company that you hope will become more valuable over time. Everyone who owns stock can theoretically win, because successful companies manufacture wealth. 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 wealth is created and 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.

A simple example of a zero-sum game is 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.

In fact, options, futures and casinos aren’t really zero-sum games: They’re 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 contests like the World Series of Poker are 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 stockbroker for 10 years. (Unlike Robert Kiyosaki, who, according to his Wikipedia page, has zero education, experience or credentials 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 this 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 tell you.

Options as a hedge

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. This is called covered call writing. 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 value of 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, such as shows on CNBC and heavily advertised websites and trading platforms that can’t wait to transform you into an active, commission-paying trader of everything from options to foreign exchange and commodity contracts.

But while these companies attempt to paint a glamorous picture of what derivatives can do for you, consider this: I lost more money learning about options the hard way than I paid for college. Seriously.

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

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

Got a question you’d like answered?

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About me

I founded Money Talks News in 1991. I’ve earned a CPA (currently inactive), and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.

Got more money questions? Browse lots more Ask Stacy answers here.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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