Fribble The Options Fribble

February 10, 1999
By Selena Maranjian (TMF Selena)

Perhaps at your company's last holiday party you heard some colleague bragging about the killing he's made in "options." You know who -- the guy whose Jaguar was repossessed last year, but who bought a new BMW this year. What are these options, you wonder?

Options are definitely not for beginning investors, and even more advanced investors should be careful. Let's say that you're thinking of buying shares in FishTop, a company that has been making revolutionary roof tiles from fish scales. You can buy shares the usual way. Or... you can buy options. There are two main types -- calls and puts. Buying a call option gives you the right to buy a set amount of shares at a set price within a certain period of time. For this right, you pay a price premium. It's the same with puts, except with them, you buy the right to sell shares. What the heck does all that mean?

Let's look at an example. If FishTop is selling for $50 per share and you expect it to rise, you could buy October $55 calls for FishTop. If, just before your option expires in October, FishTop is selling for $75 per share, you can exercise your option and buy shares for $55. Then you can keep them or sell them for $75.

If you sell, you make $20, right? Not exactly. That option wasn't free. Let's say the premium you paid was $6 per share. That means your profit is down to $14.

Some folks like options because of the leverage they offer. They point out that if you only have $1,000, you can only buy 20 shares of a $50 stock. Alternatively, that $1,000 could buy many more options tied to hundreds of shares of stock. True enough. But remember -- with options, time is of the essence. If things don't go your way in the short-term time period of the option, it will expire worthless.

The truth is that most options expire unexercised and worthless. This is because options are really about buying time, not stocks. If you're really so sure that FishTop will rise -- and I'm skeptical that anyone can regularly predict the short-term moves of stocks -- just buy its stock, and leave options to the guy with the BMW. Chances are, he won't be driving it for long.

[This has been another installment of Selena's Fribbles. If you're a glutton for the absurd, check out her archive.]