The classic way you make money in the stock market is to buy low and sell high. Of course, there is always the possibility that you will buy high and sell low, resulting in a loss. You can limit your risk while maintaining unlimited potential gains by investing in stock options instead of stock. That doesn't means options are a better investment than stocks. It just means you have more, well, options.
Every share of stock represents an equal amount of ownership in a company. Owning stock gives you the right to participate in the company's growth and to share in its losses. There are two primary ways to make money with stocks. You can sell your stock for more than you paid for it to generate capital gains. Your stock may also pay dividends, which represent your pro rata share of the company's profits. Not all stocks pay dividends, and there is always the possibility that the market price of your stock will decline, so there are definitely some risks associated with buying stock.
An option does not give you ownership in the company, but it does give you the right to purchase or sell a specific number of shares of stock at a set price, called the strike price, for a set period of time. Options are traded at a fraction of the price of the underlying stock. Once an option reaches its expiration date it becomes worthless and ceases to exist. If the price of the underlying stock drops like a rock, your risk is limited to the amount you paid for the option. If the price of the stock goes through the roof there is no limit to how much money you can make on your option.
Risk vs. Reward
There are a number of options strategies, but the most common is buying and selling call options. Each call option give you the right to purchase 100 shares of the underlying stock at the strike price. Your investment in a call option will cost you considerably less than buying 100 shares of stock. The potential upside for both the call option and the underlying stock is theoretically unlimited. The potential downside for both the call option and the underlying stock is the loss of 100 percent of your investment. You will only lose all of your investment in stock if the company goes bankrupt and there are no assets left. You are guaranteed to lose all of your investment in an option if it expires before you either sell it or exercise it.
You must determine your investment objectives and your investment temperament before you can determine whether options or stocks are the better investment for your portfolio. If your objective is to create a steady stream of income by accumulating a portfolio of dividend-paying stocks, buying options won't do you much good. If you have limited funds, but want to participate in an anticipated rise in the market price of a particular company, an option might be your best bet.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.