John Dylan was depressed. Not only had he just completed his taxes and sent off his annual tribute to Uncle Sam, but his stocks had been under-performing the market. After tabulating the results for the first quarter of the year, John figured his portfolio had lost a little over 5% of its value since the beginning of the year. Even though he knew that this was in all likelihood a short-term abberration, and that his solid investing approach would yield excellent results in the long term, John began to doubt himself.

Just in his moment of weakness, the phone rang. It was none other than the cigar-chomping Churner on the line.

"Been a rough market of late, hasn't it?" The Churner said, in the most empathetic voice he could muster.

"As a matter of fact, yes." John replied.

The Churner continued. "I understand that your portfolio of common stocks has been a real dog of late, hasn't it?"

"How'd you know that?" John said, beginning to feel a little paranoid about strangers knowing his financial situation.

"Well, uhm, yes, uhm, well, it's been a... rough market of late, hasn't it?" The Churner repeated, trying desperately to keep John on the phone. "Well, if you're looking to add a little excitement to your portfolio and want to end this sagging underperformance, I've got an idea for you... options!"

John knew a little bit about options, and had always wondered about what kind of returns they could bring to a portfolio. The initial urge to hang up on The Churner began to wane.

"Pick a stock, any stock." The Churner continued. "Forget buying the stock, just buy call options on the stock, instead of buying the stock itself. This way, when the stock goes up, we leverage our money, and our potential profit is much, much, much higher than if we just bought and held the stock. Say you bought a $0.50 call option for a $10 stock with a strike price of $12.50. If the stock price were to go to $15, we would have a profit of 400% on our initial investment, versus the 50% we would have if we had just bought and held the stock."

Just as John's interest began to pick up, his friend Motley Fool came in from the kitchen with some sun-dried tomatoes, and handed one to John.

"Taste this," said the Fool, leaning back and hanging up the phone.

"Whadja do that for?" John asked.

"Well, I guess I did it accidentally on purpose. Options are a sexy way to increase the volatility of your portfolio. But I think there are some things about options you need to be aware of."

*Why is Motley not so keen on options?*

1) Options are a zero-sum game. This means that no net wealth is created and that for every "winner" in the market there is a corresponding "loser."

2) There are too many variables with options to be concerned about. Not only does an options trader need to worry about being right about a stock's direction, which is hard enough on its own -- a trader also needs to worry about the exact timing of the move, and the magnitude of the move. Having three variables to consider instead of just one makes options extremely tough to get it right.

3) Options have high trading costs. Since they tend to be inexpensive and thinly traded, they have disproportionately large spreads and commissions associated with them. A half-point spread on a $.75 option is much larger on a percentage basis than on a $75 stock.

4) All of the above.

ANSWER

4) All of the answers are correct.

"You see, John, buying call options does indeed increase your money's leverage, but it also increases the risk. Yes, the chances of hitting a home run with an option is there, but the costs you are exposed to in order to get that shot are extremely high. Most people lose their shirt, and buy options that end up expiring worthless. Why would you want to put yourself through that kind of stress?"

John scratched his head as the Fool continued.

"If you buy a call option that expires on the 16th of the month and your stock goes through the roof on the 18th, you don't get to see any of that profit."

"I don't?" John asked.

"Nope. You see, options have a finite lifespan, whereas common stocks are essentially immortal. If the stock doesn't move during the allotted time frame, your option will expire worthless. Furthermore, if you wanted an option that had a longer time-span, you will have to pay more for it. This 'time premium' you paid slowly wilts away every day your stock doesn't move."

"Well, that kind of stinks," John muttered.

"But that's not all! Let's say your stock rises $3 just before expiration but you bought your call option $4 'out of the money.' Even though you guessed the stock's movement right, and even got the timing right, the magnitude of the movement wasn't great enough for the option to avoid expiring worthless. That's one too many variables to worry about in this Fool's book."

"It's going from bad to worse" John said.

"We can talk mechanics and 'what if' all we want," the Fool continued, "but options are indeed a zero-sum game. Unlike common stocks, where real wealth is created, and your chances of making money in the long term are almost a sure thing, the chances of making money in the long term are inverted with options. In fact, chances are you will not only underperform but that you will actually lose money over time."

"I see!" John said as he began to come around. "Why would I want to gamble on something where the historic odds say making money isn't likely?"

"Good question!" The Motley Fool replied as he waltzed back into the kitchen to strain the pasta.

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