If you’re going to engage in stock market speculation, you should stay out of stock options and warrants. Here’s why:

Stock market speculation and why doing it through stock options will most likely lead to losses

An option is a contract between a buyer and a seller, based on an underlying security, usually a stock.

The buyer pays the seller a fee, or premium, in exchange for certain rights to the stock. In exchange for the premium, the seller assumes certain obligations.

Each contract has a limited lifespan, or time to expiry. That’s usually less than nine months. The expiry date is the date on which the contract expires. The strike, or exercise price, is the price at which the rights granted to the buyer can be exercised. There are two types of options: call options and put options.

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There are a number of drawbacks with options, like high cost and limited room for error.

Part of the price that you pay when you buy an option is for “time.” And as each day passes, you lose more and more of the “time” premium. The problem is that you have to be right in three different ways with options in order to profit. Otherwise, you lose. You must accurately predict direction, magnitude and time frame.

1. Direction: In order to make money with an option, you have to be correct about the direction of the price of a stock. If you buy a call option, you’re betting the price rises. With a put option, you’re predicting the stock price will fall.
2. Magnitude: Assuming you are correct about the direction of the stock price, you also must 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. That’s because your profit won’t offset your commissions or the difference between the bid and ask prices.
3. Time: Options become valueless upon expiration. That means an option holder must be right about when the stock’s price changes—that’s on top of being right about the direction of the price change and the magnitude of the price change.

Almost all non-professional options traders wind up losing money. Professional traders follow the options market minute by minute. When a true bargain appears, they jump on it.

To make money in options, you have to out-guess other options-market participants by a large enough factor to pay commissions, which can be substantial.

In the long run, options trading is what mathematicians refer to as a “negative-sum game”: one player’s gain is less than another’s loss, because their gain is minus commissions and other costs. If you must trade options, do so as little as possible.

Warrants are another poor way to engage in stock market speculation

A warrant gives its holder the right to buy a security at a set price for a specified time.

Warrants are frequently given as a “sweetener” along with new stock issues to persuade investors to buy them.

Stock warrants are very similar to stock options but they differ in a couple of ways: Warrant issues are granted by the underlying company itself; and the longest term for an option is typically 2 to 3 years, while warrants can have an expiration of up to 15 years.

Unlike common shares, though, warrants have built-in drawbacks that add considerable risk. These include:

1. Limited room for error. Because a warrant has a fixed life, it loses some of that time value every day (that’s why it is considered a “wasting asset.”).
2. Risk of total loss. Stocks can, and do, become worthless. But a warrant holder runs a much greater risk of losing the entire amount paid for the option in a relatively short period. This risk reflects the nature of an option as a wasting asset which becomes worthless if it expires without being exercised.
3. No ownership rights. While stock ownership provides the holder with a share of the company, voting rights and rights to dividends (if any), warrant owners participate only in the potential benefit of the stock’s price movement.

To profit in warrants, you have to be right about three different factors. Your warrants have to go up (rather than sideways or down) within their fixed life, and by a large enough factor to offset what you paid for their time value. That’s why it’s so much harder to make money in warrants than in stocks.

If you want to engage in stock market speculation, our best Successful Investor advice is avoid warrants and options. Instead, buy stocks like those we recommend in our Stock Pickers Digest newsletter for more aggressive investing.

With so much risk involved, why do you think stock options have so much investor appeal?