Here at the Fool, we've often been asked, "Can you explain options to me? Not 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: BOWOW), 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 instead.
If BOWOW 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 BOWOW at $55 apiece. If, just before your options expire in October, BOWOW 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 BOWOW 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.
In fact, out of the options held until expiration, the majority expire worthless, with only a small fraction ever getting exercised. That's because options are really about buying time, not stocks. If you like the long-term prospects for BOWOW'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 available for a variety of investments. You can trade options based on stock indexes and ETFs such as SPDR Trust
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. Our Motley Fool Options team is currently offering a hands-on approach to options investing that will help you get smarter, make money, and have fun along the way. Want to learn more? Just enter your email in the box below.
This article was originally published on Feb. 24, 2006. It has been updated by Dan Caplinger, who owns shares of SPDR Trust, PowerShares QQQ, and General Electric. Google is a Motley Fool Rule Breakers selection. The Motley Fool has a disclosure policy.