There's More to Options Than You Think

Historically, the Fool has shied away from options as an investment vehicle, for reasons best stated by people smarter than us. Peter Lynch, a Foolish favorite, urged individual investors to keep away from options. And we're ever mindful of Warren Buffett's first rule: "Don't lose money." Options, by their very nature, can significantly amplify losses. Then again, as leveraging instruments, they can also amplify gains.

Options have enjoyed a much higher profile in recent years. You've seen the rise of online option trading brokerages that specialize in options trading. The Chicago Board Options Exchange (CBOE) seemingly reports record trading volumes on a monthly basis. Late-night infomercials feature alluring red-and-green-flashing software and testimonials from ordinary people who, with little to no training, have (allegedly) made fortunes in the option markets.

Trader's mania!
That last point is why we're here. This series is not intended for traders or sophisticated professionals employing complex arbitrage strategies or looking to trade volatility. Instead, we're hoping to give ordinary Fools a firm knowledge of what options are, and how to use them in hopes of improving returns.

Make no mistake: Gains from prudent option use can be both varied and spectacular. Own shares of stalwarts like Kraft (NYSE: KFT  ) or Costco (Nasdaq: COST  ) ? Why not regularly write call options on your shares to produce an extra income stream? (Mystified by the terminology? Keep reading. We'll clear things up shortly.)

Concerned that high-flying Apple (Nasdaq: AAPL  ) -- which has doubled in six months -- may face some firm-specific "Steve Jobs Organ Rejection Risk"? Perhaps you believe there is upside to beaten-down financials like Morgan Stanley (NYSE: MS  ) or Bank of America (NYSE: BAC  ) but are concerned about downside risk. You might consider buying a put option, which could protect your position if the stock subsequently tanks.

Believe that tough economic times herald more eating out at low-priced burger joints like McDonald's (NYSE: MCD  ) or back-to-school shopping at discount retailers like Family Dollar Stores (NYSE: FDO  ) ? Instead of buying shares, you could look to magnify your gains if your analysis is correct by buying calls. Heck, you could leverage those potential gains even further by combining several option positions at no cost to you -- leaving you "exposed" to receiving all potential gains. Before you get too excited, remember that you might be on the hook for potential losses, too; there's no free lunch.

We don't want you blindly acting on the advice of proprietary software and jeopardizing your hard-won profits. Instead, we want to help you make Foolish decisions regarding options.

Options are something else
Options are derivatives -- they derive their value from something else: the underlying shares of the company. Before you start using options, it's Foolish to make sure you understand that company's prospects.

For years, Warren Buffett has warned investors about the potential dire consequences of unchecked and growing derivatives use in capital markets. Then again, Buffett himself uses derivatives when he feels the market's offering him a value opportunity.

We Fools believe that 90% of individual retail investors -- that's you and me -- can happily go through life without ever buying or selling an option. But derivatives themselves (of which options are only one part) aren't inherently bad. The real problems stem from their wide proliferation and the crazy accounting with which they're associated.

Options are just tools, and they're only as good as the people using them. Shrewd use by well-educated investors can greatly enhance a portfolio's returns. Reckless, ill-informed use of options, however, can badly damage your holdings. To use options well, you've got to have a healthy understanding of the intrinsic value of the business involved. Without that most Foolish of principles, how safe do you feel in using options to leverage returns?

A few Foolish caveats
You won't find descriptions here of option trading for trading's sake. If you're interested in day trading or "black box" software, look elsewhere. Most of those programs should come with warning labels, and some should be made illegal.

Don't look here for an option-only trading approach, either. We believe that options derive their value from real businesses, whose real worth can be estimated and employed as a sturdy foundation for a Foolish options strategy.

Many people, including plenty of folks in our Foolish community, have done very well by treating options as trading instruments. If you'd like to try to follow in their footsteps, we'll point you toward some resources that might help. For the rest of you, sit back and relax. If you finish this series with a better understanding of the mechanics, risks, and potential rewards of options, we'll have done our job.

Ready to learn more? We're launching a video series designed to get you up to speed on options basics. Just enter your email in the box below for access -- it's completely free.

This article was originally published under the headline: "Options: A Foolish Introduction" on April 24, 2007. It has been updated.

Jim Gillies doesn't own shares of any companies mentioned. Costco and Apple are Stock Advisor selections. Costco is also an Inside Value pick and a Fool holding. The Fool has a disclosure policy.


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