Stock options are rather alluring. Some options can be purchased for pennies and have the potential to be worth several dollars. In other words, some stock options appear to have short-term investment potential of 20 fold.
Stock options are rather alluring. Some options can be purchased for pennies and have the potential to be worth several dollars. In other words, some stock options appear to have short-term investment potential of 20 fold. You wouldn’t have to be successful so often with that strategy to make a fortune it seems. For basic and fundamental reasons, however, options are to be avoided.
Zero sum game
: Options are a zero sum game. If you buy an option, someone (probably another investor) has accepted an exactly opposite bet on the markets. Every penny you win, he loses. Every penny you lose, he wins. Not quite. The broker also takes a commission.
Just like gambling
: Options are just like gambling. It may be fun and exciting, but if you do it long enough the house always wins. Every option bet has two parties who are hoping for exactly opposite outcomes. Both cannot win. The brokerage, like the house, gets a piece of the action on every bet.
Negative expected returns
: If you consistently and frequently invest in options, your expected return will be exactly equal to a loss in the exact amount of your total commissions. If you make 100 options trades and pay a $10 commission for each one, when all of the options have expired, you’d expect to have lost $1,000. Your gains and losses on the options would all wash each other out, and you’d be left with only the commissions as a loss.
Stocks, bonds and mutual funds are different
: When you invest in stocks and bonds and funds like mutual funds and ETFs that invest in stocks and bonds, the investment dynamic is entirely different. While it is true that, in the short run, the odds of an individual stock rising or falling are almost exactly equal to 50/50, that changes over time. The longer you hold the stock, the greater the odds of its value rising. So, too, with bonds and funds. Stocks and bonds often pay dividends. Options do not. Stocks, bonds and funds are not a zero sum game. The expected return on these investments is distinctly positive (even though people can and do lose money in the stock market).
Why do options exist
? “If options are so stupid, why do they exist?” You ask. There are legitimate uses for options as a hedge as a sort of insurance. If you own a million shares of IBM and the stock is trading for $105. You might be interested in buying an option that would give you the right to sell those shares for $100 per share if the share price dropped below $100. Using options to hedge existing investments represents a classic use of options. Often, however, options are held as speculative investments.
As you plan your family’s financial future, it is likely that stock options will have no role for you. (Employee stock options granted by your employer are another thing entirely. Accept those gladly.) There are much better investments available.
Devin Thorpe, husband, father, author of Your Mark On The World and a popular guest speaker, is a Forbes Contributor. Building on a twenty-five year career in finance and entrepreneurship that included $500 million in completed transactions, he now champions social good full time, seeking to help others succeed in their efforts to make the world a better place.