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Topic: Wealth Management

To profit from buying stock options you have to be right three different ways—and that’s virtually impossible to do consistently.

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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.

Invest in your Financial Future for FREE

Learn everything you need to know in '9 Secrets of Successful Wealth Management' for FREE from The Successful Investor.

Secrets of Successful Wealth Management: 9 steps to the life you've always wanted, before and after retirement.

 I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

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?

Comments

  • Malcolm 

    This article deals with BUYING stock options: what about SELLING stock options, especially selling Covered Call Options. When I was approached by a “stock promoter”, I mentioned that I do a fair amount of Selling Covered Calls on Blue Chip stocks, and the approach has done reasonably well for me. His answer/comment was “that is the slow way to get rich”. Do you have any comments on using this approach?

    • TSI Research 

      We don’t recommend selling covered call options.

      Selling call options generates a stream of income for the investor. However, selling calls also tends to diminish any capital gains that a portfolio might generate. When stocks you own go up, holders of the call options you have sold will exercise those options and buy the stock from you at the price fixed by the option’s terms. Meanwhile, you will want to hold on to your losers — stocks you own that are going down — to offset your obligations under the call options that you have sold.

      Options trading tends to generate a lot of brokerage commissions that eat away at the investors’ capital. Management fees and performance bonuses also erode capital.

  • Donald 

    Gentlemen:
    I very much enjoy reading your newsletters.
    I don’t disagree with anything you say about buying options. However, very little, if any, is ever said about selling options, except for covered calls.
    I like to sell put options slightly below the market price. I do this with stocks that I don’t mind owning. As you say, options are a wasting asset, which is just fine with me as I have pocketed the premium. If the option is exercised, I will buy the stock at a lower price than when the put option was sold. And, I still keep the premium. Just my thoughts on options.
    DA

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