Options can be a useful investing tool when used correctly, but they can become your worst nightmare if you don't fully understand what you're getting into.
With this in mind, we asked three of our contributing writers to talk about what investors need to know before entering the complex and often dangerous world of options trading. Here is what they had to say:
Dan Caplinger: Trading options can seem like a great way to get rich quick in the stock market, as options prices can move much more dramatically than stock prices in response to a particular news item. The big problem, though, is that the institutions that make markets in options stack the odds in their favor by maintaining large bid-ask spreads that can siphon away your money if you're not careful.
With a typical stock, the spread between what a market maker is willing to pay you if you want to sell your shares and what you'd have to pay to buy shares is generally just a penny or two, especially with popular stocks. In the options market, though, you'll sometimes find spreads of $0.50 per share or more on illiquid issues, and those spreads can represent a huge fraction of the option's overall price.
What that means is that, even if you make a smart trade, you'll lose a substantial portion of your profit to transaction-related costs -- and it will make the odds of your finding a winning trade correspondingly lower. Trading options can be a smart way to take advantage of profitable situations, but you have to be careful to watch bid-ask spreads, and to avoid circumstances in which the market maker will take away most of your profit potential.
Matt Frankel: Just like everything else in investing, there are right and wrong ways to trade options.
For most investors, buying options contracts is a bad idea. Not only are the bid/ask spreads highly skewed in the house's favor, but it's easy to lose 100% of your investment, even if the underlying stock does well, as it must do so within a tightly prescribed time period.
On the other hand, one potentially good use for options contracts is covered call writing. For instance, If I own 100 shares of Microsoft, which trade for $49.17 per share, and decide to sell a call option expiring in August with a $52.50 strike price, I can expect to collect about $80 from the sale.
If the shares are worth less than $52.50 at expiration, the option will expire worthless, and I'm free to sell another option and continue to generate income from my shares. But if the shares close above the strike price, I'd be forced to sell them for below market value.
Keep in mind, however, that if the latter were to happen, it would mean a substantial gain in the share price -- nearly 7% in my example. Thus, even if my shares get called away, it would still translate into a total return of more than 8% in just four months (including the options premium).
In short, covered call writing is not for everyone, but it can be a favorable risk/reward investment strategy when used properly.
Jordan Wathen: Options trading results in very different tax consequences than simply buying and selling stock -- though, if you don't intend to ever exercise your options, you shouldn't have much of a problem.
Options held for less than one year result in gains taxed at ordinary income rates. Options held for more than one year are taxed as long-term capital gains. This is exactly how gains on stocks are taxed.
However, exercising your options changes the tax impact entirely. Consider this example: You buy 100 options for a total of $320, including transaction costs. A little more than one year later, the options are worth $10 each. You could sell them for $1,000, netting a long-term capital gain of $680.
You like the stock, however, and decide to exercise your option to buy the stock at a price of $30 per share. Thus, your tax basis resets to $30 -- that you paid for the stock -- plus the $3.20 you paid for the option on each share. A month later, you change your mind, and sell the shares for $40 each, realizing a total gain of $680. Unfortunately, because your holding period resets when you exercise an option, the $680 gain will be treated as a short-term capital gain and will be taxed at ordinary income tax rates. You just turned a long-term gain on the option into a short-term gain on the stock, and your returns suffer for it.
The bottom line: Options create unique tax considerations that most investors will never encounter in stocks. Tread carefully.