We've been asked, "Can you explain options to me? I don't mean employee stock options, but the other kind." It's a tricky topic, but here's an overview of an answer.
Imagine you want to invest in Legal Beagles (ticker: WOOFF), a new company providing legal advice for house pets. You can buy shares the usual way -- or you can buy options.
There are two main types of options: calls and puts. A call gives you the right to buy a set number of shares, at a set price, within a certain period of time -- often just a few months. For this right, you pay a price premium. Puts are similar, but they give you the right to sell shares.
If WOOFF is selling for $50 per share and you expect it to rise, you could buy "October $55" call options for it. Let's say you snap up call options that expire in eight months and pay $6 each ($600 total) for options to buy 100 shares of WOOFF at $55 apiece. If, just before your options expire in October, WOOFF is selling for $65 per share, you can exercise your options and buy 100 shares for $5,500. Then you can keep them or sell them for $6,500.
If you sell, you make a $1,000 profit, right? Nope. You paid $600 for the options alone, remember? So, your profit is $400 (67%) -- which is still more than double the percentage return you would have gotten by owning stock.
Buying out-of-the-money call options can be risky. If WOOFF stays at $55 or falls, and you hold the option until expiration, your $600 would be entirely lost. If you decide to hold until the October expiration date, it has to top $61 per share -- $55 plus $6 -- for you to profit. Of course, if the stock makes a move up anytime in the months prior to the October expiration, you can profit on a much smaller move higher. Most option buyers do not hold all the way until expiration.
Some folks like options because of the leverage they offer. They point out that, if you have only $1,000, you can buy only 20 shares of a $50 stock. Alternatively, that $1,000 could buy many more options tied to hundreds of shares of stock. True enough. With options, though, timing is critical. If things don't go your way prior to when the option expires (expiration dates vary from days to more than two years), you would need to sell the option for a loss or risk having it expire worthless.
About 10% of options are exercised, from 55% to 60% are closed prior to expiration, and 30% to 35% expire worthless, in fact. (Those most likely to profit from options are the ones who "write" or sell the options.) That's because options are really about buying time, not stocks. If you like the long-term prospects for WOOFF's stock, but you're not sure when the stock will rise, you may prefer buying stock rather than call options. Then, if it takes longer than you expect for the stock to rise, you can either sell the shares or hang on patiently. Of course, holding stock also risks loss and ties up more of your capital.
Options are not for beginning investors, and even more advanced investors should think twice. But if you're really interested, make sure you do a lot of homework before jumping in.
Learn more in Jim Fink's "Be Your Own Casino" series and his "Dueling Fools: Options Bull" article. Jim recommends choosing a heavily traded stock with a liquid options market like Microsoft
This article was originally published on Feb. 24, 2006. It has been updated by Fool sector head Joey Khattab, who does not own any of the shares mentioned. Microsoft is an Inside Value recommendation, and Time Warner is a Stock Advisor selection. The Motley Fool has adisclosure policy.