Buying stock options will most likely make your broker happy, but your wallet might feel differently
Stock options are investment products that give you the right but not the obligation to buy a stock for a fixed price, within a fixed time period.
Buying stock options generates a lot of brokerage commissions, which is why some young, aggressive brokers recommend them for their clients.
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Buying stock options: is it worth the risk?
The first thing to realize is that a broker is far better off financially if he advises you to try your luck in stock options.
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.
So that means that stock-options trading is a great deal for brokers, because options investors 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 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.
Avoid selling or buying stock options especially if you’re preparing for retirement
Stock options are also 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, particularly if you trade in small quantities.
Stock options can also be rendered worthless. Unlike common stocks, 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. For this reason, an option is considered a “wasting asset.” Part of the price you pay for an option is for “time.” With each day that passes, you lose more and more of this “time” premium.
To profit from buying stock options, you need to be right three times
To profit in stock option investing, you have to be right in three different ways: price direction, price-change magnitude and time—and that’s virtually impossible to do consistently.
Let’s take a closer look at these three ways.
Price direction: In order to make money in stock option investing, 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.
Time: The fact that options are valueless once they expire means an option holder must not only be right about the direction of both the price change in the underlying interest and the magnitude of the move, but also about when the price change will occur. If the price of the underlying interest 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.
Our advice: Look to our aggressive stock picks instead of buying options. There’s a large element of risk in aggressive investments, but you can make money in them. In options, you will eventually lose. That’s the key difference between aggressive investing and stock option investing. If you want to invest aggressively, our best advice is to avoid options and buy stocks like those we recommend in our Power Growth Investor newsletter.
Buying and selling stock options is a great way to help your broker make money. How much have you given your broker in options commissions? Would you do it again?
