Stocks and Options: Things to Consider

Let's assume that you're interested in a start up company that has invented a new kind of technology, like an MP3 player or some similar kind of technology gadget. You're really impressed with the new product, and you believe the company is well-managed and has a great chance of becoming an extremely profitable venture. If you're interested in getting a piece of the action, so to speak, you could simply take the most direct route and acquire a certain number of shares in the company.

If the shares are selling at $100 apiece, for example, you could purchase them at this price and watch them grow considerably to, say, $200 per share. This would be a great investment with a respectable profit, even when you take into account any applicable brokerage fees and capital gains taxes.

While this is a more direct and simple approach, you could also decide to get involved in options investing instead of purchasing the stock outright. You could execute or purchase a call option which gives you the ability to purchase shares of the company at a specified price within a certain period. As an example,imagine a person or company selling you a call option could stipulate that at any time during the next six months, you will be allowed to purchase the stock at $120 per share. In exchange for the privilege of purchasing a call option, you'll have to pay a certain fee, such as $2 per share up front.

If everything goes according to plan and the share prices shoot straight up to $200 within a few months, you would have made quite a bit of money while your initial investment was only two dollars per share! To determine your profit, you would simply subtract the original price of the shares (in this case, $120) from the current price of $200. You would also have to subtract the cost of the call option itself, which we said was two dollars per share. Obviously, you would have made quite a bit of money on this investment.

So what's the issue with investing in these kinds of options? Well, obviously the above example would be every investor's dream, but in the real world things are much more volatile (which means you could stand to lose quite a bit of money).

You should keep in mind that a call option is really a gamble and not an investment in a promising company. You are playing with the short-term ups and downs of the stock market and not on the long-term potential of a given company. If you were to hold onto the shares for several years or more, this company could increase its profits (and consequently, the value of your shares) many times over. You would have lost out on this with what is in short, a short-term gamble.

While this should be obvious to any prudent investor, there is simply no guarantee that the value of the stock will rise during the term of your call option. Your initial investment (the cost of the call option per share) would be lost if the stock prices did not increase as you expected.

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