Stock options are complex derivative contracts that can be used for gambling, insurance, or income generation.
Their flexibility makes them an incredibly useful tool for investors and traders.
Many beginner investors view stock options as a form of gambling. While there is no denying that there is an element of risk when it comes to stock options, there are also several ways to minimize that risk and make informed decisions that have the potential to provide a solid return on investment.
What are stock options?
A stock option is a contract between two parties that gives the holder the right, but not the obligation, to buy or sell a security at an agreed-upon price within a certain time frame. A stock option is a bet on the future price of a stock.
There are two types of stock options: call options and put options. A call option gives the holder the right to purchase a stock at a certain price (the strike price), while a put option gives the holder the right to sell a stock at a certain price.
It’s important to note that stock options are not stocks; they are bets on the future price of stocks. When you purchase a call option, you bet the underlying asset’s price will increase. If you purchase a put option, you bet the underlying asset’s price will decrease.
- Tip: For an in-depth guide on stock options and how they work, see our lesson “101-12 What are Stock Options? How To Trade Stock Options.“
Are stock options gambling?
Stock options are a form of insurance, a source of income, or a tool for gambling. Originally, stock options were conceived as insurance, but due to their flexibility and complexity, they can also be utilized as a form of gambling. How you trade stock options defines whether they are gambling, income, or a form of insurance.
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Stock options as gambling
If a trader believes that Apple Inc. stock will increase by 10% over the next 12 months, they can buy to open 2 Apple call contracts with an expiry date of 12 months in the future. The trader bets that Apple’s stock price will continue increasing.
Because the trader has not purchased the stock and the fact that,t unlike a stock, an option can expire worthlessly, it is more like gambling or speculation. This does not make it bad; it is simply what it is.
If the trader has performed extensive research and firmly believes the stock price will rise, this does not change the fact that it is a gamble—just an informed gamble.
In other words, when you trade options, you’re essentially betting on whether a stock will go up or down in value. If you’re correct, you make money; if you’re wrong, you lose money. Because of this, some people consider options trading to be gambling.
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Stock options as insurance
Stock options are also used as insurance to protect against risk. For example, an investor holds 1,000 shares of Microsoft and enjoys the quarterly dividend income and the stock price growth over time. However, investors think that the current Federal Reserve interest rate hikes will cause a recession and decrease Microsoft’s share price.
An investor can use stock options to quantify and minimize future losses. The investor could buy put options to profit from a future drop in stock price or sell call options to earn money if the stock price does not rise.
In both cases, the investor quantifies their risk and can potentially shield themselves from larger losses.
Stock options as income
Stock options are a good way to generate additional income from your stock investments. An investor owns 1,000 Microsoft stocks worth $220K and sees a bright future. The company is doing very well, and the business climate is perfect. This investor could sell ten0 put contracts (equalling control of 1,000 Microsoft stocks) for $22K.
The investor receives the money immediately and must wait two months for the contract to expire. If the stock price stays the same or increases, the options contract will expire worthlessly, and the investor has made extra income from their investment.
However, if the stock price decreases significantly more than the option’s time value and the options contract is redeemed, the investor will be forced to sell their 1,000 stock or pay the difference to the contract owner at the strike price.
Are binary options gambling?
Yes, binary options can be considered gambling. They are based on predicting a future outcome with no guarantees. Additionally, binary options typically involve small amounts of capital and have a relatively short expiration date.
While there is the potential for profits, trading in this way carries inherent risks that may result in substantial losses. Furthermore, the terms available to traders can often be difficult to understand and not transparent. Understanding the risks and rewards associated with binary options is essential before investing.
What are the risks of trading binary options?
The biggest risk with binary options is you are betting against the market maker. When you bet against the market maker, it is like being in a casino, and the game is rigged against you. Binary options typically have short expiration dates, so your investment can quickly become a loss if the market moves against you. Furthermore, understanding the terms of the contracts is essential as they can be complicated and not clearly outlined.
The primary risk of trading binary options is that the potential losses can greatly exceed the initial investment. While some traders will make significant profits, a majority of investors also lose money due to bad decisions or simply not understanding how binary options work.
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The real risks of stock options
Options are complex, and trading options can be speculative and carry a substantial risk of loss. You need to know what you are doing when using stock options.
6 ways to reduce stock options risks
1. Don’t Sell Contracts
Buying an options contract is less risky than selling options contracts because buying puts or calls provides a fixed size of your potential loss, meaning your risk is clearly defined. Selling contracts can incur far greater losses if the stock moves unexpectedly. Only professional options traders should sell contracts.
2. Never Sell Naked Options
Avoid naked selling of options contacts. Selling options contracts naked means you are selling the option to buy a stock without actually owning the stock. Naked options are the highest risk for options traders because you may expose yourself to exponential losses.
3. Use Options as Insurance
Options can be used to hedge against risk. For instance, if you own a stock and are worried about the price dropping, you can buy a put option to protect your position. Using options as insurance on your current securities is the best way to use options.
4. Do not bet the house on an Options contract
Options contracts offer high rewards but also come with extremely high risk. It is important to be aware of the risks you take when entering an options contract and never put too much on the line. Always trade within your means and never bet more than you can afford to lose. If you are using options as a bet on a stock’s future direction, only to bet a small portion of your capital you can afford to lose.
5. Choose your Option’s expiry date wisely
One of the most crucial parts of trading Options is choosing the right expiry date. If you are buying an option as insurance for a security you currently own, choose an expiration period that will give you enough time to make gains on your position before it expires. On the other hand, if you are betting on a stock’s direction, try to pick an expiration date close enough so you don’t have to wait too long for an outcome but far enough away so that unexpected news isn’t a factor.
When betting on a stock’s future direction, ensure your option’s expiry date is far enough to allow your hypothesis to develop.
6. “In the money” and “near the money” are your friends
Ensure the options you buy are “near the money” or “in the money” to minimize your risk of the options expiring worthless.
When choosing an expiration date, “in the money” and “near the money” are your friends. These terms refer to the money made if the option expires at its current price level.
Is trading options gambling?
Yes, options trading is similar to gambling if you are betting on the direction of a stock. Options are more like insurance if you use them to protect against asset losses.
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