Steering Clear of Futures and Options

Suppose you think that IBM’s stock is a good investment. The direction that
the management team is taking impresses you, and you like the products
and services that the company offers. Profits seem to be on a positive trend;
everything’s looking up.
You can go out and buy the stock — suppose that it’s currently trading
at around $100 per share. If the price rises to $150 in the next six months,
you’ve made yourself a 50 percent profit ($150 – $100 = $50) on your original
$100 investment. (Of course, you have to pay some brokerage fees to buy and
then sell the stock.)
But instead of buying the stock outright, you can buy what are known as call
options on IBM. A call option gives you the right to buy shares of IBM under
specified terms from the person who sells you the call option. You may be
able to purchase a call option that allows you to exercise your right to buy
IBM stock at, say, $120 per share in the next six months. For this privilege,
you may pay $6 per share to the seller of that option (you will also pay trading commissions).
If IBM’s stock price skyrockets to, say, $150 in the next few months, the value
of your options that allow you to buy the stock at $120 will be worth a lot —
at least $30. You can then simply sell your options, which you bought for $6
in the example, at a huge profit — you’ve multiplied your money five-fold!
Although this talk of fat profits sounds much more exciting than simply buying
the stock directly and making far less money from a stock price increase, call
options have two big problems:
✓ You could easily lose your entire investment. If a company’s stock
price goes nowhere or rises only a little during the six-month period
when you hold the call option, the option expires as worthless, and you
lose all — that is, 100 percent — of your investment. In fact, in my example, if IBM’s stock trades at $120 or less at the time the option expires,
the option is worthless.
✓ A call option represents a short-term gamble on a company’s stock
price — not an investment in the company itself. In my example, IBM
could expand its business and profits greatly in the years and decades
ahead, but the value of the call option hinges on the ups and downs
of IBM’s stock price over a relatively short period of time (the next six
months). If the stock market happens to dip in the next six months,
IBM may get pulled down as well, despite the company’s improving
financial health.
Futures are similar to options in that both can be used as gambling instruments. Futures deal mainly with the value of commodities such as heating oil,
corn, wheat, gold, silver, and pork bellies. Futures have a delivery date that’s
in the not-too-distant future. (Do you really want bushels of wheat delivered
to your home? Or worse yet, pork bellies?) You can place a small down
payment — around 10 percent — toward the purchase of futures, thereby
greatly leveraging your “investment.” If prices fall, you need to put up more
money to keep from having your position sold.
My advice: Don’t gamble with futures and options.