How to avoid the pitfalls in options investing

Buying and selling stock options is different from regular stock transactions. You can make money in options investing, of course, but to be successful in this complex, often risky area, it’s crucial to have a firm grasp of how options investing works (and how to avoid the pitfalls that can expose you to serious risk).

How options investing works

An option is a contract between a buyer and a seller that is based on an underlying security, usually a stock. The buyer pays the seller a fee, or premium, for certain rights to the stock. In exchange for the premium, the seller assumes certain obligations.

Options trade through stock exchanges, and each options contract is for 100 shares of a particular company. So one contract quoted at $5 will cost you $500 (before commissions).

Each options investing contract has an expiration date, which gives it a limited life span (usually less than nine months). The strike price (or exercise price), is the price at which buyers can exercise their rights under the contract. There are two ways to participate in options investing:

1. Call options give the holder or buyer the right to buy the underlying security at a specified strike price until the expiration date. The seller of the call has the obligation to sell or deliver the underlying security at the strike price until the expiry date, if the option holder exercises the option.

2. Put options grant the holder or buyer the right to sell the underlying security at the strike price until the expiry date. In turn, the seller or writer of the put has the obligation to buy or take delivery of the underlying security until expiration, if the option holder exercises the option.

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Options investing by the numbers

For example, Royal Bank of Canada (symbol RY on Toronto) is now trading at around $54.00 a share.

Say you think the stock will rise in the next four months, so you decide to buy a call option on 100 shares of Royal Bank. The option has a strike price of $58, and expires in October 2010. The fee (or premium) is $2.00 a share, for a total purchase price of $200, plus brokerage commission.

For you to break even in this scenario, Royal Bank would have to rise above $60.00 by October 2010 (or the strike price plus the fee of $2.00 per share, not including commissions). That’s a rise in Royal Bank shares of about 11.1% in four months.

That’s a substantial rise – it equals 37.0% on an annualized basis. If the stock fails to rise that far — or declines from its current level, or merely holds steady — you lose money. If you fail to exercise your call option by October 2010, it will expire worthless and you will lose your entire $200 investment.

Or, let’s say you own Royal Bank and you think the stock will decline. In that case, you could sell a call option on your stock (this is known as “writing an option”) for $2.00 a share. You would then be obligated to sell your Royal Bank stock if it rises above the strike price of $58 and the buyer exercises their option.

As the option seller or writer, you keep the $2.00 a share (minus commission) in any event. But if the stock moves above $60.00, you’re forgoing gains, potentially large gains if the stock rises dramatically, because you would be obligated to sell at the $58 strike price.

Neither of these approaches has much appeal to a serious investor. The call option buyer is betting on performance over the next four months, which is essentially a random event. The call seller is giving up one of the key reasons for owning stocks – the possibility of receiving a substantial gain when a stock you own rises more than expected.

However, options trading is a major profit source for many brokers, since you pay commissions each time you buy or sell stock options. Commissions can eat up a healthy part of any stock option profits you make, while adding to your losses on unprofitable trades. That’s why few non-professional options traders wind up profiting in the long run. In fact, most options traders wind up losing money.

Aggressive stocks offer the potential for higher profits — at less risk — than options investing

Aggressive stock investments also entail a large element of risk, but you can make money in them. For one thing, you can hold on to your aggressive stocks indefinitely, since they don’t come with an expiration date.

Many investors try their luck with options trading, but few successful investors stick with it for long.

If you want to invest aggressively, you are far better off to avoid options and instead buy aggressive stocks, such as those we recommend in our Stock Pickers Digest newsletter.

The latest Stock Pickers Digest gives you our full analysis, including clear buy/sell/hold advice, on 18 stocks that may be suitable for the part of your portfolio you devote to aggressive investing. What’s, more you can get this issue absolutely free. Click here to learn how.