Buying stock options is rarely a good idea for investors, but it can be profitable for your broker
From time to time, you may hear favourable opinions on stock options from brokers or the media. Frequently, those opinions stress the relative safety of certain options as a way to hedge your investments. But they may not be as candid about the downside. The fact is, stock options carry a number of hidden risks for investors.
Stock options come in two varieties. Calls give you a right, but not the obligation, to buy a stock at a fixed price, for a fixed period. Puts give you the right, but not the obligation, to sell. But as mentioned, it’s important to realize that buying stock options comes with risk.
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Five major risks of buying stock options
Options trade through stock exchanges, and each options contract is for 100 shares of a particular company. So one contract quoted at $2 will cost you $200 (before commissions). Here are five risks associated with stock options you should know about:
Options can expire worthless: An option has a limited lifespan. You can hold common stocks indefinitely in the hope that their value will increase. A stock holder can wait out a temporary downturn in the hope of eventually realizing a profit. But every option has an expiration date. If an option is not sold or exercised prior to its expiration date, it expires and is worthless.
Costs are high: You pay commissions each time you buy or sell stock options. Commissions eat up a large part of any profits you may make with stock options, particularly if you trade in small quantities. What’s more, every trade costs you money in “slippage,” or the difference between the bid and the ask price. With options, this difference is larger than it is with stocks.
Time: The fact that options are valueless once they expire means an option holder must be right about the direction of both the price change of the stock as well as the magnitude of that change. The option holder must also be right about when the price change occurs. If the price of the underlying investment does not go far enough in the anticipated direction before the option expires, the holder will lose all, or a big part of, the investment in the option.
Price direction: In order to make money in stock options, you have to be right about the direction of a stock’s price. If you buy a call option, you’re betting the price will rise. With a put option, you’re betting the price will fall.
Magnitude: Assuming you’re right about the direction of the stock price, you must also be able to predict the minimum amount that a stock will move. If the stock moves up or down by only a small amount before expiry, you’ll still lose money.
Higher commissions may prompt a broker to steer a client into buying stock options
For instance, frequency and cost make stock option trading a great deal for brokers. In stock options, you’d pay a higher percentage commission on your outlay, perhaps 3% to 10%. Also, your stock options would have a limited life—they would expire in a fixed period of weeks or months. Then you would pay another commission to replace them.
Stock-options trading is a great deal for brokers, because options players pay much higher commissions than stock investors, and they pay commissions much more often. That’s also why options trading is a bad deal for investors.
Of course, a handful of options players do make money—after all, somebody has to win the lottery. But on average, you just can’t make enough of a gross profit to pay the commission costs and leave yourself with any significant gains. That’s why most options players wind up losing money.
How investors can profit from buying stock options
To sum up, to profit in stock option investing, you have to be right in three different ways: price direction, price-change magnitude and timing.
Our investment advice is that you should avoid the hidden risks that come with options. There are risks for common shareholders as well, of course, but these risks can be more readily identified. A successful value investing system follows a conservative, reduced-risk strategy that works especially well in unpredictable markets.
In the end, lower-risk investments equate to safer investments. For conservative investing, focus on investing in high-quality stocks that offer hidden value.
What’s your experience with buying stock options, and do you think they should remain as investment products?
Have you made money with stock options? To what do you attribute your success?
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