My brother is a gambler. He goes to the casino across the river from where he lives in Omaha, Nebraska and regularly wins money playing 21, what is more commonly referred to as blackjack.
Would I advise this as an option for someone who wishes to create wealth? Of course not!
Gambling is a good way to lose money. The house always wins in the end. Yet the stock market, and particularly the trade in stock options, is not so far from gambling. In fact, the use of words such as "spreads" and "call" when doing a little research on the subject almost made me think I was reading posts written by bookies.
Option trading is definitely not for the faint of heart. While re-familiarizing myself with options trading, I came across the following quote, written in bold face, on a page on TradeKing's website:
Options involve risk and are not suitable for all investors.My brother has a system that allows him to make money or to mitigate his losses, similar in a sense to what stock options are all about. He continues to play as long as he wins, keeps to a rule that if he loses a specific amount he quits for a certain amount of time, and only risks an amount of money that he would be comfortable in losing. It is a fairly straightforward and logical approach to what can be an emotionally charged thought process. As long as he sticks to his rules, he will keep winning... or at least not lose too much. At this point, he is up about $1000, but has not been back to the casino lately, as his winning streak ended.
That said, though options trading is very much like gambling, if you have knowledge of the stocks you are optioning, this will increase your odds of winning - or rather, to get away from gambling terms, making money. It takes discipline and indepth knowledge of the stocks, and in turn the companies that these stocks represent, though every seasoned trader knows that just because a company is making record profits doesn't mean it will be a good investment, even in the short term.
Confused? That's okay, it's just part of the business.
Knowledge helps lessen the risk of trading, and the more you learn, the better chance you have of not losing your shirt. You might even become a millionaire through savvy trading in stock options. That said, stock options are not for novice traders, and certainly not for those adverse to risk. While there is great potential to make money in options, there is a good chance that option traders will end up losing big.
Essentially, stock options are contracts. The person buying the option, known as a call option, agrees to pay a certain price, known as the "strike price", before or by a certain date, known as the "expiration date". If a stock is worth more at the time than what the buyer agreed to pay, then the buyer makes money. If it is worth less, than the buyer loses money. The buyer has the option, however, not to purchase the stock, thus the term "option", though the would-be buyer will have to pay a penalty. Essentially, the buyer is betting that the price of a stock will either increase or decrease during the period the trader has agreed to buy it, and then hopes to trade it on at a profit. The same goes for the seller, though the seller's option is known as the put option.
One of the most attractive parts of options trading is the fact that you can leverage much more money than you put in, from 100 to 1000 times the amount of capital, but this can also be a trader's undoing, as the money to cover the trade must come from somewhere, so it is essentially borrowed and the entity that covers the rest of the cost is due interest. This is essentially similar to currency trading, in which one can leverage large amounts of currency for a small fraction of what it is worth.
As with gambling, timing is everything in trading options. Brian Overby brings up some really good points about how to trade in options. It is important to have a plan before you start trading, and to follow through with this plan. He also points out that just because an option is cheap, it does not mean it is a good buy; there is usually a reason why something is selling for a bargain price. Options are meant to be liquid as well, so it is best to stay away from those that will be difficult to trade onwards. But I especially like Brian's sage advice about options, which "offer possibilities for profit in up, down, sideways AND volatile markets – but only if you’re educated on the subject". Again, the key to creating wealth in any business endeavor is knowledge.
There are also a number of myths about stock option trading, according to Ravi Prakash. While it is thought in some circles that when a stock option expires, it usually becomes worthless, this is only the case in 30% of all options. Also, since a trader can leverage more stock with less money, the risks to a trader's capital are considerably less than if buying and selling stocks outright, meaning a trader can make a far higher profit as a percentage of the money invested. Like with anything else, systems can be learned, and if these systems are adhered to, the chances of making money are increased. Other common mistakes include not doing your research, bad timing, and putting too much money into one trade. A combination of these mistakes can easily dissipate a trader's capital.
Nick Proffitt's points on trading mistakes were are an eye opener as well, and show how easy it is for a less than savvy trader to lose big. There must be a valid reason why any trader should buy, or else why buy at all? To do so without reason is just gambling, but to buy stock in a company that is undervalued is the way to go. Just ask Warren Buffett, who made his fortune doing just that. Inevitably traders in options will have to take losses, and it is better to take small ones than big ones. Knowing when to pull out of a trade takes discipline and keen insight. Diversification is also a key to mitigate losses, and the phrase "putting all your eggs in one basket" is more than just a cliché
There are so many mistakes a trader can make, but mostly they fall into three categories: bad timing, lack of research, and following the pack instead of thinking. So... with timing, research, and a cool head an option trader just might be able to become a millionaire in a short span of time... or, if an options trader's timing is off, research is wrong, or the trader fails to keep emotions out of his or her decisions, that trader just might find out what it is like to live in a cardboard box in a back alley somewhere.
