There are a variety of long-standing myths about options that need to be dispelled. The most widely held are: 1) options are too risky; 2) they’re too complicated or you’re not smart enough to use them; 3) you cannot use options inside of an IRA account; and 4) options on General Electric, for example, are no different than the exotic, highly esoteric derivatives that caused the current financial crisis.
And of course, many financial advisors have done nothing to dispel these myths. In fact, to a large degree, they have willingly helped to perpetuate them.
Misconception: Options are risky.
Risk is just the probability of an unfavorable outcome. Everyone has a threshold at which that probability becomes unacceptable. This is known as “risk tolerance.” Old thinking says buying and selling options is a high risk strategy. That reputation has always frustrated me – mainly because it is completely false. Granted, with more risk comes greater reward, but it is possible to manage the tradeoff between the two.
By their nature, options are not risky. Buying and selling an options contract is mathematically a zero sum game. There is one winner and one loser on
each side of any one option contract. When the buyer wins a dollar, the seller loses a dollar and vice versa. So, by definition, options are not inherently risky. They are a tool – a means to an end. Nothing more.
Think about the hammer in your toolbox. It is not dangerous in and of itself. But, if used carelessly, it could do real harm. Ask anyone who has smashed the dickens out of his thumb. But you don’t hear public service announcements warning you away from using hammers because they might hurt your thumb.
So, back to options. If risk is not inherent in options, why all the bad press? The problem lies in the way people are taught to use them. Options can be risky when used to place a bet on the future direction of stock price. You might just as well pile your money up in the front yard, pour gasoline all over it and strike a match. Because you are placing a bet – a highly leveraged bet, no less – on a totally random event. Would you take your life savings to a Las Vegas roulette wheel and plunk it all down on black? What do you think will happen?
It is a travesty that so many sensible investors have been suckered into crap seminars that teach you how to use options … to lose your money. It’s just wrong – and that is why the myth, that options are risky, still persists. But it is absurd to say options are risky. It is using them incorrectly – like grabbing a knife by the sharp end – that makes them risky.
Lesson One: Options are not inherently risky or safe, any more than credit cards are inherently evil. It is how you use them that makes them one or the other.
The preceding is an excerpt from my newest special report: “A Surprising Solution for Creating Sustainable Retirement Income.” You can download the full report for all five of the widely-held myths about options. Please share it with anyone you think would benefit from the information.
If reading isn’t your thing, but you really want to learn more about how to solve your biggest investment worries — whether you’re in the Dallas Fort Worth area or not — I encourage you to attend one of my upcoming Investor Briefings in January. (They are FREE! And offered both live and online.) I will discuss current trends standing between you and financial freedom and offer up solutions to your specific challenges. Register now.