Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment tips and stock market advice. Each Investor Toolkit update gives you a fundamental piece of investment advice, and shows you how you can put it into practice right away.

Today’s tip: “While stock options frequently make a lot of money for brokers, but most investors are more likely to lose with options. Here are seven ways they can cost you money.”

Trading Canadian stock options generates a lot of brokerage commissions, which is why many young, aggressive brokers specialize in it.

But many of these brokers wind up dropping out of the investment business or choosing another specialty. That’s because it’s impossible to build a lasting clientele by trading stock options, since you place your clients in investments that will almost certainly cause them to lose money.

Even so, many aggressive investors find stock options hard to resist, especially during market upturns. (For more on how stock options work, please see below.)

Here are 7 pitfalls investors face with Canadian stock options:

1. High costs: You pay commissions each time you buy or sell stock options. Commissions eat up a large part of any stock option profits you make, particularly if you trade in small quantities. In addition, every trade costs you money in “slippage,” or the difference between the bid and the ask. With options, this difference is larger than it is with stocks.
2. Limited room for error: Unlike common stocks, an option has a limited lifespan. You can hold common stocks indefinitely in the hope that their value may rise. A stock holder can wait out a temporary downturn in the hope of eventually realizing a profit. But every option has an expiration date.

   If an option is not sold or exercised prior to its expiration date, it expires and is worthless. For this reason, an option is considered a “wasting asset.” Part of the price you pay for an option is for “time.” As each day passes, you lose more and more of this “time” premium.

   To profit in stock options, you have to be right in three different ways: price direction, price-change magnitude and time frame.

3. Direction: In order to make money with stock options, you have to be right about the direction of a stock’s price. If you buy a call option, you’re betting the price will rise. With a put option, you’re betting the price will fall.

4. Magnitude: Assuming you’re right about the direction of the stock price, you must also be able to predict the minimum amount that a stock will move. If the stock moves up or down by only a small amount before expiry, you’ll still lose money.
5. Time: The fact that options are valueless once they expire means an option holder must not only be right about the direction of both the price change in the underlying interest and the magnitude of the move, but also about when the price change will occur. If the price of the underlying interest does not go far enough in the anticipated direction before the option expires, the holder will lose all, or a big part of, the investment in the option.
6. No ownership rights: While stock ownership gives the holder a share of the company, voting rights and rights to dividends (if any), option owners participate only in the potential benefit of the stock’s price movement. (Note that when an underlying stock splits, the option contracts on that stock also split.)
7. Risk of total loss: Stocks can, and do, become worthless. But an option holder runs a much greater risk of losing the entire amount paid for the option in a relatively short period of time. This risk reflects the nature of an option as a wasting asset that is worthless once it expires. If the option holder doesn’t sell the option in the secondary market or exercise it prior to its expiration date, the holder loses the entire investment in the option.

The way stock options work

An option is a contract between a buyer and a seller that is based on an underlying security, usually a stock. The buyer pays the seller a fee, or premium, for certain rights to the stock. In exchange for the premium, the seller assumes certain obligations. Options trade through stock exchanges, and each options contract is for 100 shares of a particular company. So one contract quoted at $5 will cost you $500 (before commissions).

Each contract has an expiration date, which gives it a limited life span (usually less than nine months). The strike price (or exercise price), is the price at which buyers can exercise their rights under the contract. There are two types of options:

1. Calls give the holder or buyer the right to buy the underlying security at a specified strike price until the expiration date. The seller of the call has the obligation to sell or deliver the underlying security at the strike price until the expiry date, if the option holder exercises the option.
2. Puts grant the holder or buyer the right to sell the underlying security at the strike price until the expiry date. In turn, the seller or writer of the put has the obligation to buy or take delivery of the underlying security until expiration, if the option holder exercises the option.

There’s a large element of risk in aggressive investments, but you can make money in them. In options, you will eventually lose. That’s the key difference between aggressive investing and stock option investing. If you want to invest aggressively, our best advice is to avoid options and buy stocks like those we recommend in our Stock Pickers Digest newsletter.

Tomorrow in U.S. Stock Picks we look at a rising stock that makes its profits serving the investment industry