Friday, February 22, 2008

To Win with Stock Options, Someone Has to Lose

Not to be too philosophical, but my experience has taught me that I’m best off to conduct myself as though there exists a single objective reality that applies to all of us rather than each of us having our own separate realities.

What does this mean for the investing world? If several people all buy 100 shares of ABC stock at the same time for the same price, then they will all get the same return over a given period of time. Some of these people bought ABC stock for very smart reasons, and some might have bought it because they have the initials ABC. Some of the investors are smart, some dumb, some nice, and some mean, but they will all get the same return.

This all seems obvious enough, but you have to keep it in mind when you read the come-ons for businesses that want to set you up with an account to trade stock options.

Stock options are side bets between two parties on whether a stock will go up or down. A bet that the stock will go up is called a call option, and a bet that the stock will go down is called a put option.

Descriptions of stock option strategies usually go something like this:

“If you think ABC stock is poised for a big move upward, buy call options. When ABC stock rises, you will make a lot more money than if you just bought the stock instead of the options.”

Statements like this are true because they start with “if”. But what happens if ABC stock doesn’t go up? You’ll lose your money, that’s what. For every bet you make with stock options, there is someone on the other side betting the opposite way. You can’t both win; the stock can’t go up for you, but down for the other guy.

One of you will win the bet and the other will lose. This is what is called a zero-sum game. Across everyone who plays, the total wins and losses add up to zero. Actually, it’s worse than this because of trading commissions and spreads when you buy or sell options. So, in reality, the average person involved in stock options loses money.

When you trade in options you are making bets on the stock market, but you’re not invested in the stock market. Because of this, you’re not taking advantage of the fact that the average stock market investor makes money over time. This means that stock option trading has a built-in disadvantage when compared to investing in stocks.

Before trading stock options, you should ask yourself a tough question: am I so good at predicting stock prices that I can overcome the disadvantage of trading in options rather than investing in stock directly? For the vast majority of people (including me), the answer is no.

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