Stock options are complex derivative contracts that can be used for gambling, insurance, or generating income. The flexibility of stock options 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. Put simply, 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 are betting that the underlying asset’s price will increase. If you purchase a put option, you are betting that the price of the underlying asset 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 can be used as a form of insurance, a source of income, or a tool for gambling. Originally stock options were conceived as a form of 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,e or a form of insurance.
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 is essentially making a bet that Apple’s stock price will continue to increase.
Because the trader has not actually purchased the stock and the fact that,t unlike a stock, an option can expire worthlessly, it is more like gambling or speculation. This doe not make it bad; it is simply what it is.
If the trader has performed a lot of research and firmly believes the stock price will rise, it does not change the fact 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.
You want to be a successful stock investor but don’t know where to start.
Liberated Stock Trader Pro Investing Course
Our pro investing classes are the perfect way to learn stock investing. You will learn everything you need to know about financial analysis, charts, stock screening, and portfolio building so you can start building wealth today.
★ 16 Hours of Video Lessons + eBook ★
★ Complete Financial Analysis Lessons ★
★ 6 Proven Investing Strategies ★
★ Professional Grade Stock Chart Analysis Classes ★
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. But the investor thinks that the current Federal Reserve interest rate hikes will cause a recession and therefore decrease Microsoft’s share price.
To quantify and minimize future losses, the investor can use stock options. The investor could buy put options to profit from the 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 the future is bright, the company is doing very well, and the business climate is perfect. This investor could sellten0 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,y 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.
The real risks of stock options
Options are complex, and trading options can be speculative in nature and carry a substantial risk of loss. You need to know what you are doing when using stock options.
6 ways to reduce risks when using stock options
- 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.
- 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 for options traders because you may expose yourself to exponential losses.
- Primarily using options as insurance on securities you currently own is the best way to use options.
- If you are using options as a bet on a stock’s future direction, make sure only to bet a small portion of your capital you can afford to lose.
- When betting on a stock’s future direction, ensure your option’s expiry date is far enough to allow your hypothesis to develop.
- Ensure the options you buy are near the money or in the money to minimize your risk of the options expiring worthless.
So, is trading options gambling? It depends on how you approach it. If you treat it like a casino game and place bets without doing your research first, then yes, it is very risky and could result in substantial losses. However, if you take the time to learn about different strategies and only place trades to earn income from assets you own or protect your assets, then it is more like insurance or investing.