Thinking Stock Options? Think Again.

Photo (cc) by swimparallel

Most people think to invest in stocks, you need lots of money, but that’s not necessarily true. There are ways to invest a little, but win, or lose, a lot. For example, options. They’re an investment that can make a trip to a casino look like child’s play.

I went to the New York Options Exchange a few months back to explain what options are, as well as explaining why for most investors, options are an investment best left unmade. Check out the story below, then we’ll continue the discussion below.

Understanding options

As we learned from the video above, a stock option is an investment that offers an investor the right to buy or sell an underlying stock at a specific price within a certain period of time. (An option is also a derivative – see this story I wrote a couple of weeks ago explaining what derivatives are and why they’re part of the Financial Regulatory Reform Bill). In short, a stock option is a bet on the short term price movement of a stock. You can also trade index options – same concept, but the bet is on the movement of the overall market using a stock index, such as the S&P 100.

The appeal of options is leverage. In other words, options allow you to essentially control a lot of stock for a little money. Here’s an example that will illustrate how options work.

As I write this, Apple is trading at about $247/share, so buying 100 shares would set you back roughly $24,700. Big bucks. But you can buy an option to buy 100 shares of Apple at $250/share any time between now and the August expiration for only $1,475: a fraction of the cost of buying the stock. And if you had $24,000 to invest, instead of buying just 100 shares of stock, you could use that same money to buy 16 option contracts, thus controlling 1,600 shares of Apple with the same money. That’s leverage. (Here are the prices for various Apple options.)

Fast forward to August expiration (August 20th). Say Apple rallies back to its recent high of $279. If you bought the stock, it’s now worth $27,900, and you’re up $3,200 ($27,900 minus the $24,700 you paid = $3,200). Your gain expressed as a percentage is 13%… not bad for six weeks.

But if you used options instead, you’ve made a killing, because each Apple contract is now worth $2,900. (Since the stock is now $279/share, the right to buy the stock at $250 is now worth $29 a share x 100 shares = $2,900.) If you bought $24,000 worth – 16 contracts – your total take is $46,400 (16 x $2,900), which equates to a return of nearly 100%. You’ve doubled your money in six weeks. Time to buy a Mercedes.

So that’s the upside of speculating with options: you can control a lot of stock for a little money. Now, here’s the downside. Instead of closing at $279 on August 20th, suppose Apple goes up, but only by a couple of points, to $249. If you own the stock, you’ve made a couple of hundred dollars on that two point increase, which equates to a little less than 1%. Nothing to write home about, but 1% is still more than you were making in your money market fund, so it’s nothing to complain about either.

But if you invested your entire $24,000 in options, you’re very unhappy. Your options were to buy Apple at $250/share and since the stock is now less than that and your options are expiring, they’re worth nothing at all. Zero. You’ve lost your entire investment.

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. If you’re right, the stock will be worth more. Everybody that buys can theoretically win because wealth is actually created. If Apple sells 3 million iPhones in 3 days, Apple has more money than it had before, at least if it sold them at a profit. Apple’s worth more as a company and that increased value is (theoretically) reflected in its stock price. So everybody who invested in Apple stock is a winner, and nobody lost. This is what’s known as a positive-sum game: one where everyone’s a winner, no losers.

However, stock options are a zero-sum game, because with options the only money you can make is money somebody else loses. No wealth is being created. Instead, money is transferred from the person you’re betting against. In the case of the Apple options discussed above, you were betting that Apple would rise above $250/share by August 20th. The person or institution that sold you those contracts was betting it wouldn’t. If the stock closed at $249 on August 20th, you lost, they won. If the stock closed at $279, you won and they lost.

An easier to understand example of a zero sum game is one I used in the story above: a casino. When you play poker, the only money you can possibly make is in the pot: money other players put in. Wealth isn’t being created, it’s just moving from one side of the table to the other. That’s the same thing that happens with options, commodity futures, and other types of derivative trading. Zero sum games are gambling. Putting money in things like stocks where wealth is actually created over time isn’t gambling, it’s investing.

To make matters worse, what I said above about options, futures, and casinos all being zero-sum games was too kind. They’re actually negative-sum games. Why? 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 the luckiest player in the game. That’s what the World Series of Poker is all about: finding out who that player is. Could you win in that game? Not without extreme luck or extreme skill.

The same logic applies to options. Can you make a winning bet on Apple? Sure, if you’re either smart or lucky. When you sit down at the options table, as with poker you could be playing against rubes, but you could also be playing against some of the most sophisticated players in the world. If you have inside information on Apple (which, of course, would be illegal to use) or you really feel you know more about Apple than the vast majority of professional investors, fine. Place your bets. But if you just have a “good feeling” that Apple might go up soon, the bet you’re placing is no different or more intelligent than one you’d place at a casino.

I was a stock broker for ten years. 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. No exceptions.

As I said in the story above, options do have legitimate uses. For example, they can help hedge a portfolio. If you own Apple stock and think it’s going lower between now and August 20th, you could sell the option we talked above and pocket the $1,475 you’ll receive. Or you can buy an option that increases in value if Apple goes down, thus buying a kind of insurance against a price decline.

But if you’re buying options just to speculate on the short-term price movement in some stock, you’re cruising for a bruising.

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 options can do for you, remember this: I paid more to learn to avoid speculating with options than I did for four years of university. You very well may be more successful than I was with options – but I wouldn’t bet on it.

If you’d like to learn more about options, futures, stocks real estate or other investments, check out a book I wrote a few years back, Money Made Simple.

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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