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Golden Rule #3
When you speculate, use only money you can afford to lose
Far too many people speculate with the keep-safe portion of their nest-egg. They fail to realize that speculation can ruin them just as easily as it can pay off huge potential rewards. Some words of caution:
- Do not use funds that you'll need for emergencies, your children's or grandchildren's education, basic necessities, retirement living expenses, or long-term health care. One key danger signal to watch for: If you find yourself counting on the expected gains in order to make your financial plan a success, you have probably exceeded your limits.
- Even if you do have enough capital, do not speculate if you find yourself losing sleep over it.
- Similarly, do not speculate if it causes stress between you and your significant other, or threatens other family relationships. It's not worth it.
- Certainly do not speculate if you feel it's having a negative impact on your physical health.
- If you feel comfortable with various categories of aggressive investments, do take advantage of them. They have the potential to generate very handsome profits. Nevertheless, learn as much as you can about the risks inherent in each:
Small cap and penny stocks can often suffer from poor liquidity. If a small group of large investors — or a large number of small investors — rush to buy before you do, they can drive the price you pay far above its true value. As soon as that buying pressure subsides, the price can often fall back down sharply, leaving you with severe losses. Similarly, if there is rush to sell, it can drive down the value of your shares despite no changes in the company's prospects. For more information on the risks of investing, visit the Securities Exchange Commission's (SEC) website.
Futures contracts offer very high leverage — the ability to effectively control large sums with a very small deposit. Therefore, relatively small moves in the market can bring about very large gains or losses. We do not provide futures trading recommendations. However, if you decide to play this game, be sure to learn all about the risks and the devices for controlling them, including stop losses and disciplined money management. For more information on the risks of futures, visit the website of the Commodity Trading Futures Commission (CFTC).
Options on securities: When you purchase put or call options on a stock or an index, and you stick strictly with options (never exercising them to hold positions in the underlying instruments), your risk is strictly limited to the amount you invest, plus the commission you pay your broker. However, your potential profits are not limited in any way. This can often provide a very favorable risk-reward ratio.
Indeed, provided you do not purchase expensive options, the risk limitation inherent the option itself can often be enough to protect your capital, without the need for stop-loss orders.
However, if you continue to buy losing options, your losses can still pile up over a period of time. So, like with any other speculative investment, you must never invest more than you can afford to lose.
For more details on prudent option investing, see my report 15 Rules To Get The Most Out Of Options. And for more information on the risk of options, visit the Chicago Board of Options Exchange (CBOE) website.
Options on futures: The same principles and rules apply as with options on securities: When you buy puts or calls on a futures contract, your risk is strictly limited to the price you pay, plus commissions. There is just one exception: If you exercise the option, you will be holding an actual short or long position in the underlying futures contract, which, in turn, would expose you to risk that could be greater than your original investment. Therefore, to limit your exposure, you should stick with the options only, and instruct your broker accordingly.
For more information on the risks, visit read this online brochure from the CFTC.
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