You may be as confused as the next guy when it comes to understanding stock options, and so like everyone else you go online and search for websites that explain everything you need to know about options. But did you know there are some myths floating around that are not properly explained? Here are some examples.
Myth: Employee Stock Option Plans Make You An Options Trader
I have read on several sites that employee stock options are very similar to the stock options that traders buy and sell on the open market. An option is a contract that sets a price at which shares of stock will be bought and sold in the future. The employee’s option is a way of discounting company stock so that the employee benefits from the company’s success. All other options are speculative deals called “derivatives”.
A recent news article highlighted that in some tax systems employee stock option purchase/sales are treated as personal income but if you merely purchase the shares and hold on to them, then any losses in value are treated as capital gains/losses and handled differently. You may not be able to offset your income tax bill with a capital loss (check your applicable tax laws to understand this).
Myth: Anyone Can Sell Stock Options at Any Time
There are regulations that govern when and how stock options are put up for sale. You can follow news stories about new options that open every month. But if you sign up with online options brokers you will find that they require you to put in your own money (buy the shares) before they allow you to sell them. Options trading is often described in terms of “borrowing shares from your broker”, but this idea has been borrowed by untutored bloggers from the more widely-known practice of “shorting a stock” where you sell shares at a high price and then buy them back at a low price.
If you don’t own the shares already, chances are pretty good you will not be able to sell options contracts on those shares. Even though it seems logical to you that you are only selling a “right-to-buy” to be exercised in the future, and that you will buy the shares later, this rule is intended to protect the buyer and ensure that you don’t engage in fraud. Of course, you could sell the shares after you sell the contract (with the intention to replace them later) but you still need to own the shares before you sell the option in most if not all of today’s online trading services.
Myth: Investing in Stock Options Contracts is Safer Than Investing in Stocks
Warren Buffett is famous for using insurance “float” to buy large blocks of stocks, even whole companies. Float is a complicated topic and not everyone is in a position to use it for their investing strategies. But even though Buffett has described derivatives as “financial instruments of mass destruction” he plays in that market every year. He also loses hundreds of millions of dollars on some of his stock option deals.
The idea that you’ll get extra money from selling an options contract on the shares you own is appealing. But if the numbers don’t add up you can lose a lot of money even though you get the options contract and sell the shares at a higher price than you paid for them. You have to take broker fees and taxes into consideration, and your personal situation may entail other expenses that affect your trading income.
In the best case scenario both the buyer and seller of the option will make money on the deal. In the worst case scenario both of them lose money on the deal. The guy who buys the stock option can walk away from the shares if he can get them for less on the agreed sale date, but he is still out the money he paid for the options contract. So this is no more a “safe” investment than anything else.
Myth: Emulating Warren Buffett is a Good Business Strategy
Sardar Biglari is an investment strategist who has been compared to Warren Buffett. Biglari has made a name for himself by seizing control over the Steak’n’Share restaurant chain and turning the company around. He also bought Western Sizzlin’ restaurants and a trucking insurance company. But lately Biglari’s fortunes have not gone as well as Warren Buffett’s.
Although Warren Buffett has famously lost a lot of money on some deals, his investors remain loyal to him, making the Berkshire Hathaway stock one of the most expensive in history. But Biglari’s investors are rebelling, with some of them hoping to seize control over Biglari Holdings. Just because you can bring the money together does not mean that emulating Warren Buffett’s history of investments will produce the same amount of success for you.
The same is true for buying and selling options. Warren Buffett has been making business deals for over 60 years. He has experience and insight that everyone else lacks. He also has an organization of researchers who are helping him to find these deals. Warren Buffett doesn’t just browse the Internet looking for companies that are in trouble or potential growth industries.
The Bottom Line: Learn How The Business Works First
No matter what company you are thinking of investing in, take the time to learn its business model and to understand what market forces and environmental factors affect that business model. Your investment strategies will work better if you know how an industry rises and falls. You cannot just start lobbing money into the stock market as if you are playing the lottery. You may get lucky but the chances are that doing this blindly means you will just lose your money. Don’t do that.