The Best Way to Go Broke Buying Stocks
When most people think about the stock market, they think about getting rich. Unfortunately, however, there's a darker side to it as well, leading many investors to lose money that was otherwise planned for retirement.
With this in mind, three Motley Fool contributors share their opinions below about the types of behaviors that can cause you to go broke buying stocks.
A lot of new investors use a dangerous combination of mistakes when buying stocks -- buying risky companies and doing it with margin.
It's easy to understand why volatile, risky stocks can be enticing. After all, the more risk you assume, the higher the potential for reward (usually). Stocks like Netflix, Tesla, and Amazon are all excellent companies, and have made shareholders money in the past, but their share prices are simply too volatile to allocate a large amount of your portfolio to.
An even worse idea is to buy stocks like this on margin. Let's say that you put $5,000 into a brokerage account, and use your margin privileges to buy $10,000 worth of Tesla stock.
If something happens and Tesla's share price drops, you could find yourself in a bad situation. If you buy shares with cash, a 30% decline in Tesla's share price would cause you to lose 30% of your money. But by using margin as described above, a 30% decline would lead to a 60% decline in your money.
Margin seems like a great idea when things are going well, but misuse of it can lead to a serious disaster in your portfolio.
Dan Caplinger: It's always tempting to buy shares of successful companies, especially when their stock prices have already given long-term investors great past returns. But all too often, beginning investors jump into a stock without fully understanding the business model behind it. As a result, when conditions change, those investors don't realize the ramifications on the stocks they own and can get blindsided by losses.
For instance, many investors climbed into rural telecom stocks several years ago because of their high dividend yields, assuming that like many other telecom companies, their dividends would be relatively rock-solid. Yet many of those investors didn't realize that rural telecoms would face a greater challenge in getting their customer base to keep older technology or upgrade to higher-margin services from the same provider. In many cases, big telecoms ended up competing with the rural companies they sold assets to, and that led to some players in the industry cutting their dividends and surprising shareholders. If those income-hungry investors had understood the risks of the rural telecom business model, they might have avoided their mistake.
You won't always prevent losses by studying a stock's business model. But knowing how a company works will leave you better prepared for whatever inevitable surprises pop up.
Dan Dzombak:The best way to go broke buying stocks is by selling put options. By selling a put option, you are selling to someone the right to make you buy a stock from them at a set price called a "strike price." In a rising or flat market, the put seller will frequently keep the amount collected for selling the option and the option will expire worthless for the owner. If there is a big drop in the market however put sellers can easily be wiped out.
A put option means the buyer of the option has a right to sell the underlying stock at a set price, usually below the current price the stock is trading at. The seller of the option has to buy the underlying stock from the put option owner at the set price if the put option owner desires. Each option is for 100 shares of a stock. Let's use Applefor example and we will assume a stock price of $125.
Currently, a put option expiring on January 15, 2016 with a strike price of $110 is selling for $6.75. As the seller of the put option, you collect $675 for agreeing to buy 100 shares of Apple from the buyer for $110 per share. If Apple continues to rise and is at $130 on January 15, 2016, then the buyer will be better off not using the option. If Apple at any point falls below $110 then at any point before January 15, 2016 the buyer of the option can make you buy 100 shares of Apple from them at $110 per share.
If Apple is quickly falling, this means you need to pay $11,000 in cash for the 100 shares and face an immediate loss that quickly escalates depending on the current price.
Selling options has led to many famous blowups including the Matador Fund, AIG, and Lehman Brothers. Don't count yourself among them.
The article The Best Way to Go Broke Buying Stocks originally appeared on Fool.com.
Dan Dzombak has no position in any stocks mentioned and writes about success in life in addition to failure in the stock market. Dan Caplinger owns shares of Apple.Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Apple, Netflix, and Tesla Motors. The Motley Fool owns shares of Amazon.com, Apple, Netflix, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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