- Recognize the difference between investing and speculation.
- Understand why the characteristics of stock options and short selling make them speculative as investments.
- Know why day trading can be considered speculative.
We now embark upon a very unusual part of our journey. In this and the following chapter, we will explore various speculative instruments that most of us can stay far away from without harming our investment portfolios. These advanced financial strategies should be approached only with extreme caution by the highly experienced investor, if at all. “That’s a bit odd,” you say. “Why are we learning about products that we may never use?”
The reason we are learning about things like stock options, futures contracts, cryptocurrency, and real estate speculation is that we can protect ourselves, our family members, our friends, and our colleagues from them. Think of it like this—we learn about the dangers of poisonous chemicals, but that is not instruction to use poisonous chemicals! And the same is true of options, futures, shorting, etc. We need to be familiar with how these exotic and often dangerous financial vehicles work, if only to protect ourselves and our loved ones from succumbing to their “get-rich quick” siren calls.
Investing vs. Speculation
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative” (Graham, 2006, p. 18)
Benjamin Graham was an American economist and the author of The Intelligent Investor: The Definitive Book on Value Investing, considered the bible for investors. Based on the above definition proposed by Graham and his co-author, David L. Dobb, in their Security Analysis (1934, p. 54) and quoted in their subsequent writings, an investment has a good probability of success. That does not mean that there is no risk involved.
On the other hand, speculation involves risking money on a financial instrument that has a low expectation of profitability, because success depends on chance or external factors outside of anyone’s control, rather like buying a Lotto ticket or playing slot machines at a casino. In other words, speculation is more like gambling than investing. However, if the financial product turns out—against all odds—to be profitable, it will produce abnormally high returns for the speculator to compensate for the very high risk (Nguyen, 2023).
“But isn’t someone doing it? Aren’t there people who make tremendous rates of return?” you may rightly ask. The answer is yes. They are speculators, also known as traders. Being a speculator/trader can be very profitable for the few who are good at it, but it is also very stressful and perilous.
When the task is immensely difficult and the competition is ferocious, as it is in speculating/trading or in sports or the arts, for that matter, it is only natural that a select few will rise to the top. Can you throw or hit a fastball at 98 miles per hour? If you can successfully hit a fastball at 98 miles per hour three times out of ten tries, you can snag yourself a contract for tens of millions of dollars each year playing baseball in the major leagues. Can you dunk a basketball? Can you sing the lead part in a five-act opera? Can you write or direct or act in a movie with a $100 million+ budget? The average person can’t accomplish any of these. But that does not mean that there aren’t people who can. There are. Are you going to compete with them in their venue? Probably not.
A stock options contract is a tradable right to buy or sell a certain amount of stock at a specified price for a specified period of time. Options contracts are not investments. They are speculations, which makes them more like gambling. Specifically, they are contracts between two market speculators. The buyer of the option contract gets the right to buy or sell the stock at a given price for a given period of time. If the buyer of the contract exercises the option, the seller of the option contract must buy or sell the stock according to the terms of the contract.
Options allow investors to leverage the money they paid to acquire the option. Leverage is the ability to obtain a given amount of stock while paying only a fraction of the cost. With options, you can make the same amount of money from a stock as if you bought it for full price while paying one-tenth or less of the money. Sounds too good to be true, huh? Well, you are right. It is too good to be true. Much of the time, you lose the entire outlay. Options have a time limit. Most options expire worthless.
Stock options contracts are part of a class of securities called derivatives—securities that derive their value from the price behavior of an underlying real or financial asset: in this case, the price of a stock.
- have no voting rights.
- receive no dividends or interest.
- eventually expire in a matter of days or months.
Their value comes from the fact that they allow the holder of the option to participate in the price behavior of the stock with a much lower investment of money. By the way, options contracts are usually referred to just as options (try saying, “options contracts,” three times fast!).
Options in Action
You believe that a stock will do well and that the price will increase. Instead of buying the stock, you buy an option to buy the stock. Repeat: You didn’t buy the stock; you bought an option to buy the stock. If the stock goes up, your option will go up, almost always, much, much faster and you can sell the option for a handsome profit. There is only one catch. The option expires in three, six, or nine months. If the stock does not go up in that time period, the option will expire worthless. Surprise! Most options expire worthless. There are some scenarios where options can be worthwhile, but they are few and far between.
Let’s look at an example. There is a stock currently selling for $20 that you believe will do well. Say you buy a share of the stock for $20. If it goes up to $30, you have earned $10 on a $20 investment. That’s a 50% return on your money. Pretty good! But that’s not good enough for you. Instead, you buy an option to purchase a share of the stock at $20 currently selling at $20. The option might only cost you $1. If the stock goes up to $30, your option price will probably go up to around $11. You have earned $10 on a $1 investment! That’s a 1,000% return on your money. Whoa! That is “leverage” in action. Congratulations! Pat yourself on the back!
But what if the stock price stays at $20 or goes down, even a small amount? Your option will expire worthless at the end of three, six, or nine months. And, of course, after your option expires, the stock price may zoom to $40. You were so sure that this stock was going to hit the big time and you were absolutely right. But because you bought an option that expired, you lost the ability to share in the success of the stock. Why not forget about the option and just buy the stock?!
To make the whole concept even more confusing, there are also options to sell a stock if you believe that the price of the stock will soon go down.
In essence, options are gambling, or speculating, that the price of the stock will either increase or decrease in the short term. Options have limited appeal to prudent, long-term investors.
Short selling made the headlines in early 2021, when individual investors banded together to cause huge losses for hedge funds that had sold short in stocks like GameStop and AMC Theatres. This came to be known as the GameStop Short Squeeze.
But what exactly is short selling? How can it cause such great losses?
And what was the GameStop Short Squeeze? Watch the following video to learn more:
Day Trading and Short-term Strategies
- borrowing—also called leveraging—money each day in order to buy stock, but this also substantially increases risk.
- meticulous market and news monitoring.
- quick decision-making as the stock market is fast moving.
- a large amount of speculation.
Professional day traders are typically very experienced and have a deep understanding of the markets, products, strategies, and risks.
Some people promote day trading as a way to make big money fast, and others have unfortunately fallen victim to the risks of engaging in this type of speculative investing. Someone thinking about day trading should think twice. Day trading is serious business and not something you just dabble in for fun, particularly if you are using leveraged investment strategies or trading leveraged products.
An article published on the Investopedia website reports that the estimated success rate for day traders is that only about 10% make a profit (Michael, 2023). Even more interesting is that no famous money managers or investors who have become legends—think Warren Buffet or Benjamin Graham–have built their reputation by day trading.
Before engaging in any type of day trading, it’s crucial to understand the considerable risks involved (Schock, n.d.):
- The Latest Craze: Some celebrities have been vocal about how they have made a lot of money in day trading, but this does not mean that it’s the right strategy for every investor. Every investment involves some degree of risk; however, engaging in risky trading strategies, particularly those involving leverage, is not the best way to plan for a strong financial future. While it may be exciting and tempting to jump into the latest investing craze, consider a more balanced and long-term approach to investing.
- You Can Lose Everything and More… : Day trading is not for the faint of heart as it involves minute-to-minute decision-making, as well as leveraged investment strategies that can lead to substantial losses. The goal of this kind of investing is to profit from daily short-term market and stock price changes. The risks involved, however, are substantially higher than longer-term investing strategies. A lot can happen during the market day that can result in market and stock volatility to challenge even the most experienced day trader.
- Emotional Rollercoaster: It can be especially difficult to check your emotions at the door when making investment decisions in this fast-paced environment, which may lead to some costly financial mistakes.
- Getting into Debt: Day trading often involves sophisticated products and leveraged investment strategies. Leveraged investing involves using borrowed money to purchase stocks or other securities. However, using leverage is very risky, and the risks involved may not be apparent to you at first.
- Quick Losses: If a stock’s price or the market moves in the wrong direction, it can result in very quick and substantial financial losses. Leveraged investing can even result in losing more money, and in some cases substantially more, than initially invested. Leveraged investing in a fast-paced and complicated environment can be very tricky, and it should not be done by inexperienced investors.
Unless you completely understand the magnitude of the risks involved and are able to live with those risks, you should not consider these kinds of investments. Also consider how well any investment fits in with your long-term investment plan to reach your financial goals.
Day trading can move very quickly, and you may not have time to research every investment thoroughly. Take your time and don’t ever invest in anything you haven’t thoroughly and independently researched. Most importantly, if you don’t understand the investment, don’t buy into it.
- Watch the following video
Has anyone seen promotional videos like this on making money in the stock market (or other money-making programs)? What do you think of them and what characteristics of the promotional video led you to that opinion?
- Watch this next video:
Videos like this exist because they succeed in drawing people into the fraud and making the fraudsters money. Why do you think so many people believe in these schemes? And why is that? And why again? (We ask “why” three times to dig down below surface-level responses in the spirit of critical financial literacy.)
Be A Smart Investor
Don’t speculate or gamble with your financial future. Think in terms of how to plan for the many days ahead. Research every investment opportunity, understand your risk tolerance, and create an investment plan for the long term.
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Graham, B. (2006). The intelligent investor: The definitive book on value investing (Rev. ed., updated by J. Zweig). Harper Business.
Graham, B., & Dodd, D. L. (1934). Security analysis. McGraw-Hill.
Michael, G. (2023, May 21). How to become a day trader. Investopedia. https://www.investopedia.com/financial-edge/0312/how-to-become-a-day-trader.aspx#toc-day-trading-success
Nguyen, J. (2023, July 14). Investing vs. speculating: What’s the difference? Investopedia. https://www.investopedia.com/ask/answers/09/difference-between-investing-speculating.asp
Paiano, F. (n.d.). What are options contracts? In Introduction to investments (Chap. 12, Subsection 12.1). LibreTexts: Business. https://biz.libretexts.org/Bookshelves/Finance/Introduction_to_Investments_(Paiano)/05%3A_Chapter_5/12%3A_Options_Contracts/12.01%3A_New_Page
Schock, L. (n.d.). Thinking of day trading? Know the risks. Investor.gov. https://www.investor.gov/additional-resources/spotlight/directors-take/thinking-day-trading-know-risks