Speculating with Options

Gambling with Options

Speculation
Speculation as an Investment Strategy.

 A reader's comment about how speculators look at the stock market:

ANYTHING can happen. Living with uncertainty is our job as speculators and it is why we collect risk premiums. No risk, no money.

Looking at the very large picture (see image), the US stock market, as measured by the Dow Jones Industrial Average, does its thing... trending higher as the decades pass. However, it is also obvious that there are periods in which the stock market undergoes some very serious downturns.

 

Investors don't have a lot of choice. By definition, their goal is to participate in the long-term upward trend. To do that, they are told to remain fully invested at all times and to add to their holdings when the market declines. For the most part, that strategy works. However, there are less risky strategies for investors who adopt risk-reducing option strategies..

However, there were periods where investors were hurt and it took many years for them to recover losses (as measured from the stock market highs. The two major examples occurred in 1929 and 1966 when ~30 years passed before the market returned to its previous highs.

Such market actions convert some people away from long-term investing and they become speculators -- by holding positions for much less time. That strategy requires predicting in which direction the stock market (or an individual stock) will move over the short term.

Not an easy task.

Let's not confuse speculators with traders. The latter also try to time the market, but their holding periods are very short (a few seconds to a few hours) -- something that is impossible for people who have full-time jobs. Trading is a job that requires paying attention when the markets are open, and doing homework when they are closed.

 

 

Options as a Speculator's Tool

While I am a strong believer that it is best to use options as risk reducing investment tools, it is a very common practice to adopt speculative (i.e., gambling with an edge) strategies with options. People who do that always believe that they have an edge. That advantage is most often derived from using charts (i.e., technical analysis) to predict future price movements. It can also come from playing a strong hunch that a specific stock (or the whole market) will make a good-sized move over a short time.

As our comment writer noted, when we sell options, we collect a "risk premium." That is how the options world works: Option buyers pay a premium and transfer risk to the option seller. In turn, the option seller can reduce his/her risk by creating a spread position. For example, when selling a put, the speculator can buy another put -- one that is farther out of the money -- and create a put spread. This is much less risky (and less rewarding) than selling the naked put option.

Speculators also buy options. This represents a limited-loss strategy, but it comes with the opportunity to earn a huge return. And let's be honest -- that dream is the driving force behind speculating.

The downside is that buyers must be correct on the direction of the stock market -- plus that price change must occur within a limited time (before the option expires).

Although the idea of placing a wager on market direction is known as speculating, when options are used, there are two basic ways to go.

  • Buy options. This strategy allows for large profits, but comes with smaller probability of earning a profit.
     
  • Sell options. Get paid to accept risk. In return for that risk, the seller usually wins a high percentage of the trades -- but without careful risk management, losses can be devastating. Thus, I recommend selling spreads instead of selling naked options.

​Options are a useful tool for speculators, investors, and traders.