Investor Toolkit: 3 risks of investing in Canadian stock options

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific advice on successful investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Today’s tip: “Treat Canadian stock options like lottery tickets, because the odds are almost as bad.”

Canadian 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 $5 will cost you $500 (before commissions). Here are three risks you face when you invest in Canadian stock options:

• High leverage, few bargains: Options enthusiasts dwell on leverage. You pay a pittance to buy a call or put, and that’s all you can lose. But you make a huge profit if the price of the underlying security moves in your favour — up if you bought a call, down if you bought a put. However, option sellers, or “writers,” also try to make a profit. In fact, due to the interplay of buyers and sellers, options trade about where they should, most of the time. Bargains are rare.

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• High costs: To profit in options, you have to outguess other traders by a large enough margin to pay transaction costs. Commissions are just the start. You also lose money to the “spread” — the 5% to 50% difference between the highest bid and lowest ask. (You’d lose that much if you bought at the offer and sold at the bid.)
• Filtering out your profit: If you pay the offer when you buy, or accept the bid when you sell, your order gets filled immediately. But this raises your transaction costs. If you enter a price between the bid and ask, and hope your order gets filled, you introduce a filter. You’ll always get a “fill” on options that are diving, but never on those that are about to soar.

Investment opinion: Options occasionally make sense for tax purposes, or during an uncertain takeover bid. The rest of the time, this is recreational investing: you do it for fun, not profit. Most investors who buy Canadian stock options wind up losing money. That’s why most investors should avoid options, most of the time.

Next Wednesday, October 6, 2010, Investor Toolkit will look at how to put stock-price trends in perspective.

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