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 (but not the obligation) 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 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 and pay $6 each ($600 total) for options to buy 100 shares of WOOFF at $55 apiece. If, just before your options expire, 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 down to $400 -- less, when you account for trading commissions.
Options are often risky (though there are ways to reduce your risk with them). If WOOFF stays at $55 or falls, your $600 would be entirely lost. It has to top $61 per share -- $55 plus $6 -- by October for you to profit.
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. With options, though, timing is critical. If things don't go your way in a short time frame, your option will expire worthless.
Most options expire unexercised and 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're sure that WOOFF's stock will rise, you're probably best off buying its stock. Then, if it doesn't behave as you expected it to, you can either sell the shares or hang on patiently.
Options are not for beginning investors, and even more advanced investors might consider steering clear. But if you're really interested, make sure you do a lot of homework before jumping in.
Here are some articles on options:
Consider sticking with good old stocks -- and exceptional mutual funds. We can point you to a bunch of very promising ones at no cost to you.
More from The Motley Fool
3-Plus Reasons to Be Happy About Rising Interest Rates
Yes, rising interest rates mean higher mortgage payments. But there are some rather significant upsides to higher rates, too. See if you'll benefit.
Bitcoin Investing: Avoid These 2 "New" Cryptocompanies
The cryptocurrency boom is starting to feel a lot like the dot-com bubble of the late 1990s.
Why Did Twenty-First Century Fox, Inc. Gain 25% in 2017?
The company made a major change toward the end of the year.