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Options Trading and Gambling, Are they the Same?
Some people might think options trading is just a euphemism for gambling. While there are some similarities between options trading and gambling, it is false to use these terms interchangeably. This article aims to present a brief history of trading options and gambling and shed light on both terms, explaining what they exactly are. This eliminates the misunderstandings that may prevent you from investing in a potentially profitable financial instrument. Also, you can find out if you qualify to be an options trader or, for that matter, a gambler. Therefore, you gain perspective on whether options trading or gambling is a losing game for you or not.
What is gambling?
According to Wikipedia, gambling, also known as betting, refers to wagering something valuable on a random event with the hopes of winning something else of value. In gambling, the involved parties mostly engage in the activity because they feel lucky or have a feeling that the other party is doomed to lose. In other words, the gambler can hardly ever objectively calculate the odds of winning or losing. Moreover, gambling results are usually immediate, and the gambler only has to wait for the wheel to stop spinning or the horse to cross the finish line, etc.
Approaches to gambling
We can place approaches to gambling on a continuum which views the act as a sin on one end and a financial asset on the other end. The opponents of gambling believe that it ultimately results in the transfer of wealth from the lower classes to the higher classes, widening the gap between the rich and the poor. On the other hand, proponents of gambling believe it is a profitable industry and participation in the act is entirely voluntary. Additionally, supporters argue that gambling provides much of tax revenues without the need to increase tax rates. On the whole, approaches to gambling are ambivalent since the practice has financial benefits and, all the while, might be detrimental to society.
History of Gambling
Gambling has a long history, with evidence of its existence in ancient civilizations such as China, Rome, and Egypt and religious texts like the Bible. Originally associated with divination and seeking knowledge of the future, gambling gradually transitioned into betting on outcomes. The casting of lots, including the use of dice, was prevalent in various cultures, even as a means of justice. In Europe, gambling faced bans and condemnation but remained popular across society. Lotteries emerged in the 15th century as the first form of organized gambling to benefit governments and authorities. With the legalization of gambling in the 17th century, some mathematicians tried to find a scientific explanation for the odds of winning or losing. Their attempts laid the foundation of the probability theory.
Moreover, sports betting gained organized and sanctioned recognition in the late 18th century. Over time, the perception of gambling shifted from being seen as a sin to vice and eventually to an essentially harmless and entertaining activity. The advent of the internet further expanded gambling accessibility. By the 21st century, four out of five people in Western countries had occasionally gambled. However, this increase also brought attention to the issue of pathological gambling, which was recognized as a cognitive disorder affecting over 1% of the population.
What is Options Trading?
Before defining options trading, it is crucial to explain what derivatives are. Basically put, a derivative is a security with a price. It is a financial contract between two or more parties whose value is dependent on an underlying asset. The value of a derivative comes from the fluctuations in the underlying asset. Investors use derivatives to hedge their investments, leverage their holdings, and speculate on the direction movements of the underlying asset. Investors can trade these assets in brokerages and trade them on exchanges or OTC.
Options are a kind of derivative where the investor has the option to buy or sell -depending on the type of contract- the underlying asset, hence the name. These financial instruments provide a unique opportunity for market participants to manage risk, speculate on price movements, and optimize their investment strategies. The flexibility offered by options stems from the fact that they grant the holder (i.e., buyer) the right, but not the obligation, to exercise the contract at a predetermined price, known as the strike price, within a specified time period. This time period, known as the expiration date (or maturity), adds a layer of complexity to options trading, as investors must carefully consider the potential price movements and volatility within that timeframe.
Types of Options
- Call vs Put Options
There are two main types of options, call and put. Call options give the holder the right to buy the underlying asset at a predetermined price within a specified time period. On the other hand, put options grant the investor the right to sell the underlying asset at a predetermined price within a specified time period. In other words, in a call option, the buyer is bullish on the underlying asset, and the seller is bearish. On the contrary, in a put option, the buyer is bearish on the underlying asset, and the seller is bullish.
Investors who expect an increase in the underlying asset’s price use the call option. Conversely, those who anticipate the underlying asset’s price to decrease use the put option. In either case, if the underlying asset’s price accords with the investors’ anticipations, they gain profits. The classification of options as calls or puts is crucial for understanding the rights and obligations associated with each type, and it forms the basis for constructing various options trading strategies.
- American vs European Options
We can also classify options in terms of exercise time into American and European options. By way of explanation, American options allow the holder to exercise the option whenever they want before the expiry date. On the contrary, in European options, the holder can exercise the option only on the contract’s expiry date. Therefore, flexibility in exercise time is what distinguishes American from European options. It should be noted that the options’ names do not have anything to do with the region.
Are American options better than European options?
American options allow traders to use a variety of strategies to gain profits because they have more control over the contract. American options are especially good for volatile assets because the holders can adjust their position based on the underlying asset’s price movements. This allows the holders to lock their profits or mitigate the losses. Of course, American options are more complex than the European options for the same reason, i.e., flexibility. That is, holders need to be more careful about the timing of exercising the options.
European options make up for the inflexibility with lower prices. That is, European options are more cost-effective than American options, especially for less volatile assets. Generally, traders who do not intend to exercise the options before maturity tend to use the European options. Additionally, the European options are easier to deal with due to the fact that the holder can exercise them only at the expiry date.
History of Trading Options
Trading options, as we know them today, can be traced back to the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked a pivotal moment in the history of options trading, providing a standardized marketplace for their exchange. However, the concept of options, in terms of the ability to buy or sell assets at a predetermined price, has a much longer history. It can be traced back to the mid-fourth century BC when philosopher Thales of Miletus created the first known options contracts, albeit in a simpler form. This demonstrates that while the modern options market emerged in the 20th century, the basic concept has been part of financial activities for over two millennia.
Early Examples of Trading Options
- Olive Harvest
In the fourth century BC, Aristotle documented an early example of options in his book “Politics.” The story revolved around Thales of Miletus, a philosopher with a keen interest in astronomy and mathematics. Thales utilized his knowledge to predict a bountiful olive harvest and sought to profit from it. With limited funds, he couldn’t own all the olives, so he paid the owners for the rights to use them during the harvest. Thales sold his rights to those in need when the anticipated abundant harvest materialized, earning a significant profit. By doing so, Thales essentially created the concept of a call option, as he paid for the right, without obligation, to use the product at a fixed price and subsequently exercised his options for financial gain. This early example demonstrates the fundamental principle behind modern call options, with various financial instruments and commodities replacing olive presses as underlying securities.
- Tulip Bulb Mania
The Tulip Bulb Mania took place in the 17th century in the Netherlands. Tulips became a symbol of the high social class among the Dutch aristocrats, and the demand for tulip bulbs skyrocketed, resulting in exorbitant prices. In this period, options were being used for hedging purposes in various markets, including the tulip industry. Tulip growers bought puts to safeguard their profits in case bulb prices fell, while wholesalers purchased calls to protect against rising prices. These options contracts were not as sophisticated as today’s and were traded in an informal and unregulated market. As the tulip bulb prices soared, a secondary market for tulip bulb options emerged, attracting widespread speculation. However, the bubble eventually burst, causing a severe economic downturn as prices collapsed. Many investors who had risked everything on the tulip bulb market went bankrupt, leading to a tarnished reputation for options worldwide.
Was Trading Options Illegal in the Past?
Despite the negative reputation associated with options contracts, their appeal persisted due to their leverage power. Options trading faced opposition and was banned multiple times throughout history, particularly in Europe, Japan, and certain states in America. Notably, London, England, enacted a ban on options in the early eighteenth century, which lasted for over a century. By the late 16th century, there was developed a system for calls and puts. Nonetheless, the opposers of the trading options outnumbered the supports, and thus, options trading was banned in the 18th century. It wasn’t until the nineteenth century that the ban on options in London was lifted, marking a significant milestone in their acceptance and legalization.
Development of Call-Put Brokers
In the late 19th century, American financier Russell Sage played a significant role in the development of options trading. He created call and put options that could be traded over the counter, marking a breakthrough for the industry, despite the absence of a formal exchange market. Sage also pioneered the establishment of a pricing relationship between options, underlying security prices, and interest rates. He utilized put-call parity to devise synthetic loans by buying stock and a related put option, effectively loaning money to customers at fixed interest rates. Although Sage eventually ceased trading due to substantial losses, his contributions were instrumental in the evolution of options trading. During this period, brokers and dealers began placing advertisements to attract buyers and sellers of options contracts. Still, pricing and liquidity remained challenging due to the absence of regulation and standardized practices.
The Regulation of Trading Options
During the early 20th century, call and put brokers primarily controlled options trading with over the counter contracts. Although some standardization existed, the market lacked liquidity and proper pricing structures. The Securities and Exchange Commission (SEC) in the United States introduced limited regulation, but options trading saw slow progress, and complexities hindered widespread adoption.
In 1968, the Chicago Board of Trade faced declining commodity futures trading and sought new opportunities. After careful consideration, they established a formal exchange for options contracts dubbed Chicago Board Options Exchange. With the foundation of the CBOE in 1973, trading options acquired a standardized marketplace which addressed issues such as inconsistent pricing and uncreditable transactions. Concurrently, the Options Clearing Corporation was established to ensure proper contract fulfilment and centralized transparency. These developments brought legitimacy and stability to the options market, alleviating investor concerns. After over two millennia since Thales created the first call option, options trading finally gained recognition as a legitimate investment instrument.
The Black-Sholes Pricing Model
In 1973, CBOE launched with limited contract listings, primarily focusing on calls due to the absence of standardized puts at that time. The options market faced resistance as determining the fair value of options proved challenging, leading to wide spreads and low liquidity. However, a significant breakthrough occurred the same year when professors Fisher Black and Myron Scholes introduced the Black Scholes Pricing Model. This mathematical formula provided a means to calculate options prices using specified variables, revolutionizing the options market and instilling greater confidence among investors.
The impact of the Black-Scholes Pricing Model was profound. By 1974, the average daily trading volume on the CBOE surpassed 20,000 contracts, signifying a rapid growth in options trading. The following year witnessed the opening of two more options trading floors in the United States, further expanding the market. In 1977, the availability of options increased as more stocks were added for trading, and puts were introduced, providing investors with a broader range of choices. As the 20th century progressed, the rise of online trading platforms made options trading more accessible to a global audience, attracting both seasoned professionals and aspiring traders. Today, the options market thrives with thousands of listed contracts on various exchanges, facilitating millions of contracts traded daily and demonstrating the enduring popularity and ongoing growth of options trading.
What are the Risks of Trading Options?
Like any other investment, investing in options involves risking your capital. However, thanks to the intricacies of the options market, the investor must act more carefully to prevent losses. The following are some of the factors to consider when analyzing the risks of investing in the options market.
Options trading has gained popularity among investors, but liquidity issues can still arise, particularly for fewer mainstream options with low trading volumes. This can pose challenges when executing trades at favorable prices, especially for those dealing with larger volumes. Although exchanges employ market makers to enhance liquidity, the risk of insufficient liquidity remains, presenting an additional concern for traders.
- Trading costs
The cost of trading options is closely tied to their liquidity and involves both indirect and direct costs. The bid-ask spread, representing the difference between the buying and selling prices, serves as an indirect cost that increases with larger spreads. Limited liquidity can lead to bigger spreads, posing a potential risk. Additionally, the direct costs of trading options include broker commissions, which can be higher than other investments. These costs are particularly relevant in options trading due to strategies involving multiple positions, which result in higher commission fees. Traders should consider these costs when planning their investment strategies.
- Time decay
One inevitable risk is the impact of time decay. Options incorporate a time value component, and generally, the longer the time until expiration, the greater the time value. Consequently, as time passes, the value of the options you possess will gradually decrease. Although this doesn’t imply a constant decline in value, time decay can have a negative effect on the value of held options.
Why do Traders Need to Trade Options?
Options trading is cost-effective.
There are several occasions when traders decide to trade options. The first reason for trading options is when the trader has limited capital and wants to do more with less. For example, if an investor has $10,000 and wants to buy 100 shares of a $50 stock, they must pay $5000 and use most of their capital on a single stock. However, if they purchase a $20 call contract (representing 100 shares), the total outlay would be $2000. This gives the investor the chance to spend the remaining $8000 at their discretion. Therefore, trading options allow the trader to spend less but earn as much as when they invest in more expensive markets.
Options can hedge traders’ investments against fluctuations.
Another reason why investors trade options is that they can hedge their investments. When used properly, options can reduce investment risks because they do not require as much financial commitment as equities. Also, gap openings do not affect options, and they are safer than equities in this regard.
To illustrate, let’s say you buy a stock at $50 and want to protect your investment from significant losses. You place a stop-loss order at $45 to prevent losses any more than 10% of your investment. However, the stop-loss order is only active during trading hours. So, if your stock closes at $51, but overnight, negative news breaks and your stock plummets to $20 at the market open, your shares will be sold at $20. This is because the first trade is below your stop order price of $45. Alternatively, a put option could have provided better protection. Unlike stop orders, options remain active outside of market hours, offering continuous insurance. This is why financial experts view options as a reliable hedging tool.
Options provide a variety of investment choices.
One major advantage of options is their versatility in providing various investment alternatives. Options can be used to create synthetic positions, which offer multiple ways to achieve the same investment objectives. This flexibility can be highly beneficial to investors. While synthetic positions are rather complicated, options offer numerous other strategic alternatives. For instance, when it comes to shorting stocks, some brokers charge high margin fees or even disallow it entirely. However, options provide a solution by allowing investors to purchase puts and profit from downward moves without facing such restrictions. This flexibility gives options traders an advantage over traditional stock trading.
Moreover, options enable investors to trade beyond just the direction of stock movements. They allow traders to capitalize on factors such as time passage and volatility fluctuations—the so-called “third dimension” of the market. Since most stocks experience limited price changes most of the time, the ability to take advantage of stagnant markets becomes crucial in achieving financial goals. Options provide the necessary strategic alternatives to profit in all types of market conditions, giving investors a more comprehensive toolkit for success. By leveraging options, investors can go beyond the limitations of traditional stock trading and unlock additional opportunities for profitability.
Why do People Gamble?
It is fun.
Nowadays, gambling is a part of recreational activities, and most gamblers do it for the sheer fun of it. Gambling can make everyday events (usually with binary outcomes) more interesting. For instance, some friends might bet on the gender of their pregnant friend’s baby and add some excitement to the due date for themselves. Also, a trip to a city with famous casinos can tempt the person to spin the wheel and test their fortune.
It can be profitable.
Another reason why people gamble is the hope of earning some money while having fun. People who gamble to make money usually believe that the activity follows a certain pattern. They try to employ some sort of strategy to increase their chance of winning. A seasoned poker player, for example, has a better command of the game and is more likely to win. But skillfulness does not make gambling less risky, and it is not wise to rely on gambling as a source of income.
To escape the stress of life.
Some people gamble due to psychological issues. Studies show that 9 to 12 million people in the United States, as well as their families, have gambling problems. That is, they obsessively engage in gambling and spend almost all their time and money on the activity as a temporary respite from reality. Experts believe problem gambling can result from several reasons, including the environment and psychological disorders. For example, the children of gambling parents are likely to suffer from problem gambling when they grow up. Moreover, some gamblers suffer from gambler’s fallacy, or the delusion that their winning is more probable or that they are invincible. Usually, this group of gamblers become addicted to gambling and needs psychological counselling.
Is Options Trading like Gambling?
The short answer to this question is no. But for an in-depth analysis, let’s go over the similarities and differences. Regarding the similarities, we could say that both activities involve risking your capital in the hopes of gaining profits. The second similarity is that options trading involves speculation and taking positions based on anticipated outcomes, just like some types of gambling, such as betting on sports or stock market movements. Participants evaluate the information at hand and base their decisions on their expectations for the future. The third common point between options trading and gambling is that they trigger the same psychological responses in participants, such as excitement and thrill.
Nonetheless, the differences between the two activities overshadow the similarities. For one thing, in gambling, the participants have little or no control over managing the risk, while options traders can employ different strategies or tools, such as stop-loss orders to control the potential loss. The second notable difference between options trading and gambling is that traders need extensive knowledge of the market and analyze multiple factors before taking a position, but gamblers need only a rudimentary understanding of the game’s rules. In other words, gambling mainly relies on luck, but trading requires logic and knowledge. The third significant difference is that the options market is fully regulated and centralized, while gambling has various rules and regulations based on where it is held.
“While there are some similarities between options trading and gambling, it is false to use these terms interchangeably.”
Is Trading Options Halal or Haram?
Being Halal (virtue) or Haram (sin) is a fundamental question in Islamic regions for all major and minor aspects of life. Halal deeds or things are promoted, and Haram ones are prevented and punished, often severely. Most Islamic “Imams” (or religious scholars) do not recognize trading options as a Halal activity. In the eyes of Islamic mullahs, trading is more like a game of chance, and the only way to bend the laws of Sharia is if the buyer actually holds the underlying asset. Of course, a minority of Islamic mullahs see the good in trading options. They believe it is a hedging instrument that guards investors’ funds, and therefore, it is Halal. On the whole, you will not find a devoted Muslim trading options thanks to their beliefs or due to financial penalties.
Options trading and gambling are two different activities that have some overlaps. Participants in both activities need to assess their resources and come up with a risk management scheme to control the potential losses. However, trading options and gambling are not legal in some parts of the world, especially Islamic states and the residents had better avoid these activities.
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