Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re an aggressive or a conservative investor, these weekly updates are designed to give you specific investment advice. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away. Today’s tip: “There are 5 ways in which stock options can cost you money.” From time to time, you may hear favourable opinions on stock options from brokers or the media. Frequently, those opinions stress the relative safety of certain options as a way to hedge your investments. But they may not be as candid about the downside. The fact is, stock options carry a number of hidden risks for investors. Stock options come in two varieties. Calls give you a right, but not the obligation, to buy a stock at a fixed price, for a fixed period. Puts give you the right, but not the obligation, to sell. Options trade through stock exchanges, and each options contract is for 100 shares of a particular company. So one contract quoted at $2 will cost you $200 (before commissions). Here are 5 risks with stock options you should know about:
- Costs are high: You pay commissions each time you buy or sell stock options. Commissions eat up a large part of any profits you may make with stock options, particularly if you trade in small quantities. What’s more, every trade costs you money in “slippage,” or the difference between the bid and the ask. With options, this difference is larger than it is with stocks.
- Options can expire worthless: Unlike common stocks, an option has a limited lifespan. You can hold common stocks indefinitely in the hope that their value will increase. A stock holder can wait out a temporary downturn in the hope of eventually realizing a profit. But every option has an expiration date.
If an option is not sold or exercised prior to its expiration date, it expires and is worthless. For this reason, an option is considered a “wasting asset.” Part of the price you pay for an option is for “time.” With each day that passes, you lose more and more of this “time” premium.
To profit in stock option investing, you have to be right in three different ways: price direction, price-change magnitude and time.
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- Price direction: In order to make money in stock options, you have to be right about the direction of a stock’s price. If you buy a call option, you’re betting the price will rise. With a put option, you’re betting the price will fall.
- Magnitude: Assuming you’re right about the direction of the stock price, you must also be able to predict the minimum amount that a stock will move. If the stock moves up or down by only a small amount before expiry, you’ll still lose money.
- Time: The fact that options are valueless once they expire means an option holder must not only be right about the direction of both the price change in the underlying interest and the magnitude of the move, but also about when the price change will occur. If the price of the underlying investment does not go far enough in the anticipated direction before the option expires, the holder will lose all, or a big part of, the investment in the option.
Our investment advice is that you should avoid the hidden risks that come with options. There are risks for common shareholders as well, of course, but these risks can be clearly identified. My value investing system follows a conservative, reduced-risk strategy that works especially well in unpredictable markets. If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.
