Are you an investor or a gambler? The stock market knows4 min read . Updated: 13 Sep 2020, 09:02 AM IST
- Small, inexperienced traders are piling into options, which can be a cheap way to hit the jackpot if you know what you’re doing. If you don't, losses can accumulate quickly.
You should learn whether you’re an investor or a gambler before the market teaches you the difference.
Stock gamblers are on the rise. But, sooner or later, they will lose most—if not all—of their recent gains.
Just look at options trading, which has been surging. Many traders use options as a cheap way to try hitting the jackpot: stock-market Powerball.
In late August, a record 62% of premiums paid for options initiating bets on rising stock prices came from people buying no more than 10 contracts. (The long-term average is 34%.) Nearly all such small-fry are inexperienced retail traders, says Jason Goepfert of Sundial Capital Research in Minneapolis, which tracks market sentiment.
In the week ending Sept. 4 alone, says Mr. Goepfert, small traders shelled out $11.5 billion this way—an all-time high and nine times last year’s average. To put that week’s bets in perspective, in all of fiscal 2019 Americans spent $91 billion on lottery tickets.
Derived from the Latin optio, or “choice," an option entitles but doesn’t obligate you to buy or sell an underlying security at a fixed “strike price" anytime until the option expires.
A “call" option can pay off if a stock rises; a “put," if it falls.
Let’s say you’re optimistic about a stock and it rises above the strike price of your call before expiration. You then can sell or exercise the option and earn a bigger profit with a smaller cash outlay than if you had bought the stock outright.
On the other hand, if you expect a stock to fall, and it drops below the strike price before expiration, you can sell your put. You would make more money than if you had bet against the stock by selling it short.
Earlier this week, for instance, you could buy a call option on 100 shares of Apple Inc. with a strike price of $125 per share expiring Oct. 2. Your premium, or cost, was $3.30 per share. So Apple would have to hit $128.30 by Oct. 2 for you to break even.
If Apple, trading then around $117, were to rise above $128.30 by the beginning of October, you could sell your option at a quick profit.
If Apple hit $130, your options contract would be worth that minus the $125 strike price, or $5. You paid a $3.30 premium, leaving you a gain of $1.70 per share, or $170 on your outlay of $330. That’s a 50% return in less than a month.
If Apple’s stock doesn’t go above $125, the most you could lose is your $330 premium.
So why doesn’t everybody trade options all the time?
Because it’s risky.
Stocks and other securities don’t always go up—-or down, for that matter. Which way they move, and how much and when, can stupefy even the most experienced professionals.
And, although stock trades are free at most brokerages, you can’t trade options—win or lose—without paying the premium. Guess wrong a few times, and you’ll be out thousands of dollars with nothing to show for it but a churning stomach.
You’ll also pay your broker a “spread," often five or 10 cents and up per options contract, or at least $5 to $10 on an option tied to 100 shares. And short-term capital-gains taxes will eat into your profits like acid.
Because demand for options rises in sharply fluctuating markets, “premiums are higher than normal right now, so retail options buyers need sizable moves to make money," warns Joanne Hill, head of research and strategy at Cboe Vest, a firm in McLean, Va., that designs and manages option-based strategies.
As jumpy as markets have been recently, they’d have to get even jumpier in a hurry to fulfill the dreams of many newbie traders.
Small losses aren’t likely to discourage such speculators.
In her new book, “Innumeracy in the Wild: Misunderstanding and Misusing Numbers," psychologist Ellen Peters of the University of Oregon shows that a potential gain “comes alive with feeling" when people know they also can lose a little money.
Consider an experiment. One group of people is asked how much they would like to take a wager with a roughly 20% chance of winning some money. The catch is that there’s an 80% chance they will suffer a very small loss. Another group is asked how much they would like to make a similar bet if they had the same chance to win, but with no chance of losing anything.
You’d think the second group would rate that wager as more attractive. You’d be wrong.
It turns out the possibility of winning doesn’t seem that thrilling if nothing is at stake. Comparing a possible profit against the potential of a small loss makes the gain feel bigger and better.
Surprisingly, the more numerate people are, the stronger this effect seems to become.
“Numbers may be counted, sorted and manipulated by our thinking minds," writes Prof. Peters, “but, in the end, numbers influence and inform choices through our feeling minds."
No wonder trading can become an addiction. Surveys among individual traders in the Netherlands and in France found that roughly 4% met standard criteria for compulsive gambling.
Among the signs that someone is a trading addict: escalating trades to sustain excitement, borrowing money from friends or family to cover losses, lying about losses, and attempting and failing to quit.
If this sounds like you, confess to your friends or family and get help before the market cures you the hard way: with massive losses that can wreck your life.
As experienced gamblers understand, it’s vital to know what kind of game you’re playing. Some forms of gambling—blackjack and poker are good examples—involve large amounts of skill alongside luck. Others, like the lottery or slot machines or roulette, depend almost entirely on luck.
Trading options involves lots of skill if you know what you’re doing—and nothing but luck if you don’t.
Disclaimer: This story has been published from a wire agency feed without modifications to the text.