No, I'm Not Playing With Fire

My Foolish colleague Paul Elliott recently wrote an article likening options use to dumb kids on motorcycles, arguing that either can leave you for dead. That's why, he says, he avoids them.

Now, as he points out, motorcycles are neither inherently good nor bad -- they're just a means of transportation that can be used well or foolishly. Similarly, options are neither good nor bad, but rather, are simply tools. As with any tool, proper education in handling and use is key.

And much like Paul, and his teenaged realization that, while motorcycles were cool, he'd probably personally get himself killed, the lesson for the options user is not "Abandon All Hope, Ye Who Enter Here."

Instead, it's "Investor, Know Thyself."

You see, Paul has used options
Or rather, Paul has invested in ways that mimic how options behave. Let me explain.

Consider a simple call option, which gives its holder the right to buy the underlying stock at a pre-specified price (the strike price) any time up to expiration, which might range from as little as a day to well over two years. At expiration, the decision is pretty simple -– if the stock price is greater than the strike price, you buy the stock. If the stock price lags the strike, you don't.

At its root, a call option has a binary outcome: Profits or nothing.

Paul's self-admitted weapon of choice in the 1990s was small biotech companies. Such companies are generally cash-burning engines, hoping that the wonder drug they've got in their pipelines will prove more effective than a sugar pill and get bought up by the likes of GlaxoSmithKline (NYSE: GSK  ) or sanofi-aventis (NYSE: SNY  ) . If the drug's a hit, it's probably a multibagger. If it isn't, they'll likely bleed out via cash burn, leaving their investors with nothing.

A binary outcome: big-profits-or-bupkis. Doesn't that sound like a call option?

What's love got to do with it?
Paul goes on to say that while he eschewed Cisco (Nasdaq: CSCO  ) and Oracle (Nasdaq: ORCL  ) and other stocks that "everybody loved" (I imagine valuation was a concern there), he admits to "falling in love" with his own stocks. And the consequences of that, dear Fools, is exactly what options can help you prevent.

Why? Options depend on a clear valuation of the underlying stock. Once you've got a firm valuation, you can overlay an appropriate options strategy.

Take Apple (Nasdaq: AAPL  ) , for example, which is one people often fall in love with. I admire the company immensely, but the stock is too pricey for me on a valuation basis, so I won't buy it.

But options -- employed Foolishly -- give us more choices regarding fair Apple. You could sell a put option at a strike price lower than today's trading price, which nets you cash up front and guarantees a lower future purchase price if Apple's price falls.

If you already own Apple and think that there's some hefty growth assumptions built into the present price, you could sell a call option at a higher strike price, guaranteeing that you'd sell at a still higher price (one that your valuation work tells you is assuredly overvalued) while gaining some income.

And there are any number of other strategies you could put into play to mirror your beliefs about Apple's prospects vis-a-vis the present valuation -- bullish, bearish, or neutral.

At bottom, options are simply an extension of the buy-and-hold belief in valuation -- they just offer more ways to profit on a given company.

Knocking down the straw man
Can investors wipe themselves out with options trades, the way Paul's friend did?

Well, sure. Remember, Paul never bought a motorcycle because he knew he'd do something stupid. His friend, on the other hand, actually did something stupid -- using options as if they were betting chips and getting suitably slapped for his speculation. If you're blindsided by a massive five-figure loss, I'd bet you went into the transaction not having worked through the potential outcomes.

But that's true of buying stocks long, too. Just take a look at the 10-year stock price charts for Alcatel-Lucent, JDS Uniphase (Nasdaq: JDSU  ) , or Ballard Power, not to mention the recent performance of stocks like Citigroup (NYSE: C  ) or AIG.

Ironically, when stocks are overvalued, it's an options strategy -- buying puts -- that can enable investors to protect their money while watching to see if the market euphoria might continue to rack up gains.

Getting wiped out via option use is an oft-trotted out fear, but you can wipe yourself out perfectly effectively by buying stocks on anything other than ongoing valuation.

(What's So Funny 'Bout) Peace, Love, and Understanding?
All of this is not to dog on Paul (much). I actually share his opinion that the vast majority of individual investors can happily go through their investing lives without ever buying or selling an option. And sure, acting stupidly is bound to end badly -- no matter what arena we're talking about.

But investors who are committed to valuation and interested in taking a more active role, enhancing their returns, generating some additional income, or protecting their hard-won gains should seriously consider options, which can do all of that and more, and without necessarily adding any additional risk.

If you want to find out how -- and how we're using options Foolishly, based on business fundamentals and valuation -- just enter your e-mail in the box below to access Jeff Fischer's free educational video series on options.

Fool analyst Jim Gillies owns no shares of any company mentioned. Apple is a Motley Fool Stock Advisor recommendation. The Fool's disclosure policy is never stupid.


Read/Post Comments (16) | Recommend This Article (58)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 31, 2009, at 4:42 PM, colleran wrote:

    Wait. Don't Call Options cost anything? Some profit or some loss. And you have to be willing to pay close attention to the stocks you have options on. Finally, options are not investing. They are betting.

  • Report this Comment On July 31, 2009, at 5:31 PM, RobertC314 wrote:

    I would say no more betting that buying a stock in the first place. Paying an option premium is no different that paying a premium on the stock price of a popular company (see: AAPL)

  • Report this Comment On July 31, 2009, at 7:07 PM, gaswelldealer wrote:

    everyone is missing the covered call where you get paid up front and your only loss is potential lost gains greater than those you set when you wrote the covered call

  • Report this Comment On July 31, 2009, at 9:00 PM, HTPinHCMC wrote:

    I'm with Colleran on this one. I use MF to find good long term stock ideas to build a portfolio I can retire on. Then I go back to my day job.

    If you are going to enter into arrangements which depend on short to medium term market movements you need to be the kind of person who is watching the market on a day to day basis and think you know which way it will swing.

    Or perhaps you want to limit your downside if the market goes against you in the short to medium term, but I guess my eye is on where a stock may be in 5 to 10 years, not 3 months to 2 years.

    I have no problem with MF offering people help in getting into short term deals, but I hope they don't loose sight of people like me that pay for premium services in order to access good long term stock advice.

    H

  • Report this Comment On July 31, 2009, at 10:24 PM, XMFRael wrote:

    The good news, h (funny aside, my old guitar player in my rock and roll days -- see i'm not such a weenie, after all -- was named h) is that i don't think the Fool will ever lose sight of old-school investors like you. "Investing" will always be The Motley Fool's bread and butter.

  • Report this Comment On July 31, 2009, at 10:54 PM, thisislabor wrote:

    huh. options and general investing. all at the same location? now were talking value.

  • Report this Comment On August 01, 2009, at 5:13 AM, CarryOnAgain wrote:

    Colleran, do you use stop losses on your stock positions? I ask that because a buy 'em and forget 'em strategy can lead to huge losses. We've seen what happened to financials, home builders and auto manufacturing. Woe betide those who bought these stocks at their highs and forgot 'em.

    My point here is that if you had instead bought options you would only have lost the premium of the options which has to be a lot better. You could have used the hypotherical stop loss as the amount to invest in the options position, which is obviously a lot less than buying the stocks outright. You can buy long term Leaps which go out 2 years. If your position hasn't gone up in that time I would suggest you have picked the wrong stock. Even 1 year is plenty to see some action on a so-called value stock. Why would you be willing to wait multiple years for one of these stock picks to move? That doesn't sound like a good strategy to me. Economists call that opportunity costs lost.

    No, buying options forces you to focus on time frames and confront the consequences of your decisions. Holding fallen stocks for years hoping for a recovery is to deny reality.

  • Report this Comment On August 01, 2009, at 12:49 PM, atsitaba wrote:

    Motorbikes are inherently dangerouse because of their instability, speed and lack of rider protection. So are options because of your lack of control over execution prices, specially those thinly traded.

    Austin

  • Report this Comment On August 01, 2009, at 3:54 PM, kayakmastr wrote:

    I have made more on the MF Pro options advice this year than on selling stocks, but that doesn't include appreciation on stocks I continue to hold. The ideas of selling a covered call on a stock that you own and would like to sell, and selling a put on a stock that you would like to buy, makes more money than just buying and selling stocks.

  • Report this Comment On August 01, 2009, at 10:37 PM, NoMoreSnoozing wrote:

    We often fear what we don't understand. Personally, I'm happy to learn about options, and I look forward to learning more about them. I'm sure there are some great techniques and tradeoffs out there involving options that will serve my investing objectives well.

    For example, I am the type who can't stand the thought of leaving my positions unprotected by not having an automatic exit strategy in place, e.g., a trailing stop - like others here, I don't have time to watch the market every day, so I feel this is a necessary evil.

    Buying a put gives me much greater downside protection than a trailing stop, and it allows me to pull the trigger when and only when I want to. However, for these enhancements, I pay a premium.

    To characterize one of these techniques as "gambling", but not the other, is ingenuous. There are costs and risks associated with both.

  • Report this Comment On August 02, 2009, at 8:20 AM, imakecoffee wrote:

    I need some help undestanding the statement:

    if the stock price is greater than the strike price, you buy the stock. If the stock price lags the strike, you don't

    when the expiration date occurs, you don't buy the stock if it's lower that you'd initially identified? I must be missing the concept. I would think that buying it at a price lower than what you'd initially identified would be a bargain.

    Would someone explain, please? I can see I am missing this.

  • Report this Comment On August 02, 2009, at 1:02 PM, TMFCanuck wrote:

    Hi imakecoffee,

    It's pretty simple - no worries.

    Imagine you have own a $20 call option a stock (meaning, you can buy the stock for $20).

    If, at expiry, the stock's price is $30, you'd obviously exercise the call and buy the stock for $20 (since you can immediately turn it around and sell it for $30...good deal).

    If, on the other hand, the stock's price is $15, you'd NOT exercise the option to buy at $20, since you could just go buy the stock on the open market for $15.

    Does that make sense?

    Best,

    Jim

  • Report this Comment On August 05, 2009, at 8:10 AM, imakecoffee wrote:

    Thanks Jim I got it.

    I am going to watch the video presentation, just available and learn some more.

    Have a good one!

    Chris

  • Report this Comment On August 05, 2009, at 8:33 PM, mikenrobin wrote:

    I'm really interested in this option thing and I'm set up with Scottrade to use options. But, I'm not knowledgeable enough yet to jump in. Is there anywhere I can take a stock and theoretically buy or sell using options. Say a program that you use an actual real time stock quote to see what would happen if you had used an option?

    Mike

  • Report this Comment On August 05, 2009, at 9:25 PM, footchester wrote:

    Stop loss = lost mega profit.

    Purchased CFSG @$8.35

    Price in March 09 – $5.62

    “stop loss” kicks in and stock sold at 30% loss

    fortunately, I don’t believe in stop loss for any stock that has been properly researched, so stock rebounds and I sell in August @ $16.77 for 100% gain

    or SLT, purchased @ $5.10

    stock drops to $4.25 in March, ‘traders’ bail from stock, as do 'stop loss' "investors"

    stock rebounds and I sell on Monday @ $14.29 for 200% gain

  • Report this Comment On August 05, 2009, at 10:50 PM, TMFFischer wrote:

    Greetings,

    Here's another article published today, about options:

    http://www.fool.com/investing/general/2009/08/05/a-strategy-...

    Best,

    Jeff

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