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When Buying Options Is Like Gambling (And When It's Not)

Have you ever thought of buying a put or call option like gambling?

I hear professional traders use the term "bet" when talking about options, and even stocks sometimes. My stock buddies sometimes also say 'bet' when they talk about taking a short position. I believe that if you do careful study and homework on a stock, and believe in the long term prospects of the company, that's not gambling, that's a risk-adjusted choice that the stock has more potential than your money sitting in the bank getting no interest and slowly depreciating by (OK, very low right now) inflation. Or, if you already have a portfolio, that you like a stock enough to invest more, or all over again, or that you like one stock over another. How about options? Are options best left to professionals or can the average Joe individual investor actually make money on options? Are options a risky venture, sort of like Vegas at the keyboard? Or are they lower risk? Well, that depends on your knowledge base.

When Options are Like Gambling

A lot of people like gambling. Just go to your nearest Casino to find out how much people love to throw their money away! Why not just buy a put or a call from the comfort of your living room; at least you have 50/50 odds! Well, sort of. At your on-line broker's site, you don't get music, or a free drink, or the exciting sounds and lights, and no Cirque du Soleil either! Hmmm... It's not sounding so fun.

Options are like gambling when:

*You don't know the stock very well

*You purchase an option on a volatile stock or hard to value one

* You have no clear short or long thesis

*You don't understand the delta (how much the option moves relative to the underlying stock) or the theta (amount of time decay) of the option. Interpretation: you may not understand that the option is a leveraged investment and therefore the % gain or loss goes up or down like crazy when the stock moves; also an option loses value over time.

Scared yet? No problem--roll the dice!!! If the above sounds like you-be not lazy at home on the keyboard-fly to Vegas, Atlantic City or your nearby gambling town-you will have lots more fun. Seriously, there's no harm in buying an option if the above sounds like you, just realize it's gambling, not investing. And don't go whole hog-just spend what you want to lose.

As an example, I bought an option on Linked In (NYSE:LNKD) before the quarterly report conference call, to "play the quarter" and I won! I had an over 100% "win" overnight! I had used the website, but knew nothing about the company. Pretty much most of the above applied to me. Even though it was a good bet, now I wish I just had the stock, or exercised the option. Of course, you know what they say about hind sight. I got lucky, pure and simple.

An opposite example is when I bought a put on Tesla (NASDAQ:TSLA); I mean, really, a P/E of infinity, a 100 Price/Book a -180% ROE, with a 16 B market cap; super over-valued, right? Not really; never underestimate a cult momentum stock in a bull market! I lost everything I gained on the LNKD call and more.

Options When You do the Homework

As another example, I bought two call options in American Tower (NYSE:AMT) after researching the company and liking the stock post-analysis. I bought the Jan 14 $82.50 calls for $3.75 (now worth $0.85 for a -77% loss) and the Oct 13 $85.00 calls for $1.63 (now worth $0.11 for a 93% loss) both options now have zero intrinsic value.

The stock went from $74.40 on June 19 to $70.22 today (-5.6% loss). So you can see how time and leverage work against your option position, especially with OTM (out of the money) calls, which have less or no intrinsic value. Intrinsic value is the amount of the option price that holds its value, while the extrinsic part decays over time. ITM (in the money) options have more intrinsic value as they get deeper ITM. I could have bought deeper in the money call options, but they are a lot more expensive, and I didn't.

Would you rather risk $375 + $163 = $538 (one option each) and control 200 shares and risk losing it all or buy 200 shares outright and risk whatever amount you think the stock may decline? In this case, I believe I would have been better off buying the stock and just losing 5.6% ($833), since it looks like the stock will not get to $85.00 by October, but, you never know! Other folks say I lost, or will lose $538 rather than $833, so I'm ahead, but I really believe in the stock, so I think it will go up again.

The real issue with the logic in this last sentence is that I never planned to buy 200 shares! As I usually leg into stocks (buy them incrementally) I would have owned 50 shares and lost $209 compared to the nearer dated option that lost $163. Even though I would have lost more on the stock, I would still rather have the stock than the option, as long as I'm convinced in the long term story of it, because at expiration, the option has zero value. Once lost, the option premium (price of the option) becomes a sunk cost, never to return; the stock has potential to return to its original value, and thus has a value.

But wait! You say-isn't that gambling too-I mean you lost right? To me, not really, it was a calculated risk; I did the best I could analyzing the stock, picking the option, and the unexpected happened-one analyst wrote a bad report on the stock and it went down. My point is that if I had spent the capital on the stock, rather than the option, I would have the same thesis today as I did then, but I'd have the $163 sunk in the stock (albeit at a lower value) that has some value rather than the option which will have no value if it expires worthless in October (we'll see).

The Trickiness of Options

The difficulty with options is that you have to get the timing AND the direction right, and it's tough enough just to get the direction right! Stocks may not reflect their true underlying value for many months, and by that time, the option has typically expired.

For most individual investors, therefore, my belief is that they should not "invest" using options. It's too much work, and you really have to know what you are doing to make money. Just buy the stock for companies you really believe in.

When Options are Not Like Gambling

Options can be used for all sorts of interesting ideas and strategies, including hedging (a form of insurance for when stocks go down), as stock replacement, for extra income on steady stocks (covered calls), for income on stocks you want to own (cash secured puts), and complex strategies that attempt to eliminate some or all of the time decay of options (spreads and more). The problem with all of these strategies is that nothing is for free-either you have to accept option price decay over time, your upside gain is limited or your downside risk is not limited, or worse-both. In general, use the 10/10 rule for options (and I would modify that to lucky 7/7!!): have no more than 7% of your capital in options, and only use options 7% of the time. This will help to limit risk exposure.

Options are not like gambling when you have a situation that is pretty much the opposite of when it is like gambling:

*You know the stock well and have done your research and homework, including the technicals

*You understand the volatility of the underlying stock

* You have a clear long or short thesis or flat thesis and you know exactly why you are entering the trade

*You have an exit strategy for the trade if it does not go your way

*You understand the delta (how much the option moves relative to the underlying stock) and the theta (amount of time decay) of the option, and the resultant intrinsic and extrinsic value and have chosen the option strike price according to your risk tolerance and comfort level

*For complex trades (spreads, etc.) you have modeled the profit/loss

By the way, most options brokers will give you a 'fake account' with fake money in it to learn all about options. This is a super way to learn about trading options (I recommend doing this for a full 5 months first!) so you don't lose a lot of real money.

Conclusion

Buying/selling options is not recommended unless you are a pro, or have read a few books on options, spent a few months paper trading, and have done your homework both on the underlying stock and the option. The average Joe individual investor loses money on options over time (the house wins, in this case the market makers). If, however, you want to do some armchair gambling, and you have an options account or approval for options and money to blow, and you really enjoy it, go for it!