by Archie M. Richards, Jr., CFP^®
February 21, 2005

Avoid call options. They're dangerous. Here's the story - key terms are italicized:

Let's say a stock is priced at $20. You expect it to rise within 6 months. You buy a call that gives you the right (not the obligation) to buy the underlying stock at a price of $20 a share any time in the next 6 months. The contract costs $2.

The $20 is the strike price. The $2 is the premium. Since the two are the same, the option is on the money. The premium has time value only and no intrinsic value. (The meaning of those two terms will become clear.)

If the stock price rises to $22 within six months, you buy the stock ("call" it) and pay the $20 strike price. You then sell the stock for $22, making $2. But since the contract cost $2, you break even.

If the price fails to rise by 10 percent to $22 before expiration, the option expires worthless, and you lose all your premium money.

Let's say the price of the stock rises from $20 to $24 within 6 months. You call the stock at $20 and sell it for $24, making $4. The contract cost $2. On a 20 percent rise in the stock price, you double your money. If the price rises to $30, you make five times your money ($30 less $20, divided by $2).

Making several times your money sounds like fun. But remember, it's hard enough to be right about the direction of an individual stock. Banking on the price moving significantly in the right direction within a short time is too much to ask. Most people who buy call options lose.

Okay, back to the beginning. The stock is again priced at $20. You buy a six-month call option with a strike price of only $18. The option is in the money by $2. You pay a premium of $3. The premium has $2 intrinsic value and $1 time value.

If the price rises to $21, you call the stock at $18 and sell it for $21, making $3. Since the contract cost $3, you break even.

If the price rises by 10 percent to $22, your profit is 50 percent. If the price rises to $30, you make four times your money ($30 less $18, divided by $3).

In-the-money options are safer than on-the-money options, but they're still highly speculative. Stocks seldom make big moves in a short time.

Once more, the stock is priced at $20. You buy a six-month call with a strike price of $22. The option is out of the money by $2. The premium is $1, all time value.

If the price rises to $21, you break even. If it rises to $22; you double your money. If it rises to $30; you make ten times your money. But out-of-the-money calls are the riskiest of all.

Here are additional characteristics of options:

• Minimum option purchases are for 100 shares. On 100 shares, a premium of $2 would cost $200.

• It's easy to lose all the money you place in option premiums -- no trouble at all.

• Expiration times vary from one day to several years. The options traded most actively last for three months and six months. Options that expire a year or more in the future are called leaps.

• When you call a stock, it's bought from the person from whom you bought the option. That person is called the writer.

• You're not required to hold an option until maturity. Most people don't. They buy and sell the options themselves.

• Premiums have a natural tendency to fall, because time values shrink to zero by expiration. Time values shrink slowly when expiration is months away; they shrink rapidly as expiration draws near. At expiration, the contract has no time value, but if it's in the money, it does have intrinsic value.

• Option commissions are high, and the spreads between the bid and asked prices are wide. Options are not only risky, they're expensive.

Options are perilous. If you buy them at all, acquire leaps. Otherwise, avoid options altogether.