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.
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!
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.
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.