Understanding stock options will lead you to see them as highly speculative investments—and more like a gamble than a sure thing

While it’s possible to make money in stock options, it’s important to realize that there’s a large element of risk in these speculative investments—and you will most likely eventually lose money. That’s a key difference between aggressive stock investing and stock option investing.

Understanding stock options and the limited room for error helps you understand your risk

Unlike common stocks, options have limited lifespans. You can hold common stocks indefinitely in the hope that their value may rise. A stockholder 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 is worthless. For this reason, an option is considered a “wasting asset.” Part of the price you pay for an option is for “time.” As each day passes, you lose more and more of this “time” premium. To profit in stock options, you have to be right in three different ways: price direction, price-change magnitude, and time frame.

Understanding stock options: Calls and puts

There are two main types of options: call options and put options.

Call options give the holder or buyer the right to buy the underlying security at a specified strike price until the expiration date. The seller of the call has the obligation to sell or deliver the underlying security at the strike price until the expiry date.

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Put options grant the holder or buyer the right to sell the underlying security at the strike price until the expiry date. In turn, the seller or writer of the put has the obligation to buy or take delivery of the underlying security until expiration.

Look beyond broker marketing to understand options trading and its risk

Buying stock options generates a lot of brokerage commissions, which is why some young, aggressive brokers recommend them for their clients.

In stock options, you’ll pay a higher-percentage commission on your outlay, perhaps 3% to 10%. Also, your stock options will have a limited life, expiring in a fixed period of weeks or months. Then you’ll pay another commission to replace them.

Stock-options trading is a great deal for brokers, because options investors pay much higher commissions than stock investors; they also pay commissions more frequently. That’s why options trading is generally a bad deal for investors.

Of course, a handful of options investors 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 investors wind up losing money.

Understanding stock options includes learning about the role of “market makers”

Options players often wind up buying from or selling to options “market makers.” These market makers are full-time, highly skilled professionals who are employees of/or partners in options-brokerage firms. They don’t pay commissions in any real sense; instead, they share in the commissions that their firms receive.

Market makers trade both sides of the market—that is, they write new options contracts whenever they think they can profit by doing so. They don’t guess right every time, of course. However, they do guess right (or close enough) much more often than options players who are non-professionals.

Understanding stock options means understanding how they can hurt your retirement

Stock options are not a smart idea if you’re headed into retirement. As mentioned, stock options are expensive to trade and 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. That’s especially the case if you trade in small quantities.

Use our three-part Successful Investor approach to make better investments

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Are stock options part of your aggressive investing strategy, or do you prefer other types of aggressive investments with better upside?

What is your understanding of stock options? Do you feel like they belong in your portfolio?