Investor Toolkit: Stock option investing comes with 5 hidden risks

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 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: “5 ways stock option investing will cost you money”

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 you face in stock option investing:

1. Costs are high: You pay commissions each time you buy or sell stock options. Commissions eat up a large part of any stock option investing profits you make, particularly if you trade in small quantities. In addition, 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.
2. 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 may rise. 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.” As each day 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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3. Price direction: In order to make money in stock option investing, 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.
4. 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.
5. 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 interest 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 advice: Look to our aggressive picks instead of options. There’s a large element of risk in aggressive investments, but you can make money in them. In options, you will eventually lose. That’s the key difference between aggressive investing and stock option investing. If you want to invest aggressively, our best advice is to avoid options and buy stocks like those we recommend in our Stock Pickers Digest newsletter.

The latest issue gives you our full analysis, including clear buy/sell/hold advice, on 19 stocks that may be suitable for the part of your portfolio you devote to aggressive investing. What’s more, you can get this issue, 5 in-depth Special Reports and access to our weekly Email/Telephone Hotline absolutely FREE. Click here to learn how.

Next Wednesday, June 15, 2011, Investor Toolkit will look at the risks of “theme investing.”