Options? Are You Nuts?!

Well, so much for that summer rally.

At minimum, it looks like we're in for a period of heavy back-and-forth volatility like that we saw several months ago.

What does that mean for our portfolios?

For me, that means taking a careful look at strategies that can generate profits in volatile markets. I have a core of great stocks that I plan to hold for many years, but I also have some cash from profits I took in recent weeks. While holding cash during periods of heavy volatility isn't the worst strategy, I'd like to find a way to put that cash to work.

I don't mean day-trading the volatility. While that can work for some, the odds aren't great -- and I don't want to spend my days hovering over market feeds anyway.

But what has my attention at the moment is the options market.

Options? Like, stock options? Seriously?
I know that for many Fools, the idea of entering the options market is a daunting one. For me, for years, as a guy who focused (personally and professionally) on retirement investing, it was one of those things, like day-trading currency futures and running Ponzi schemes, that was on the other side of the wall between common sense and greed-fired insanity, one of --

Wait a minute. Stop.

What?

Options? Are you NUTS?!!

Do you mean I'm nuts because I'm learning about how to use options? Or nuts because I'm hearing voices in my head calling me nuts?

Listen, I'm here for your own good, or at least the good of your portfolio. Options are for crazy people -- or at least for pros, those guys at Goldman Sachs (NYSE: GS  ) or Morgan Stanley (NYSE: MS  ) or wherever that have the super-hyper-fast trading systems and years of experience. You can't compete with those folks!

I don't need to "compete" with those folks. There are several ways for individual investors to use options to add return to a reasonable, risk-managed portfolio, while --

Y'know, I see those guys on the TV, in those ads talking about how you can make a bazillion dollars trading options at home with their special software or whatever. And you used to tell me to stay away, that for most people options trading is a big-time money-loser just like those foreign currency trading things. Now you're telling me I should learn about options?

Yeah. I'm not talking about "trading options." I'm talking about using them prudently. Just because some people burn themselves doesn't mean fire is always a bad tool, does it?

Seriously, stop. I remember back in the old days how the Fool used to go on about how people should just stay away from options. "Options are to be avoided, period." I bet all that stuff is still in the archives on the site. Now you're telling me that it's OK?

You know what? I used to believe all that stuff too, and I used to advise folks to just stay away from the options market. But I've been reading Jeff Fischer's options tutorials --

Fischer? Who's that?

He's the lead advisor for the Motley Fool Pro service. Very, very smart guy. Good writer, too -- he's great at explaining things clearly. Anyway, as part of the Pro service, he created a series of tutorials on ways that smart, non-crazy individual investors -- us Fools -- can use options to make money without undue risk.

I'll give you an example. Do you know what puts and calls are?

Yeah, I know that much. A put is an option that gives you the right to sell a stock at a specific price by a specific time, and a call gives you the right to buy a stock at a specific price by a specific time.

And you know that you can sell options as well as buy them?

You mean like issue them?

Yeah. It's called "writing" options. Anyway, here's the example -- we're going to write something called covered calls as an income-generating strategy. "Covered" means we own the underlying stock -- you never want to write the other kind, called naked calls, because that is an extremely risky strategy.

First, you look for a big-company stock that's fairly stable and hopefully pays a dividend. Any of these would be possibilities:

Stock

CAPS Rating

Dividend Yield

Johnson & Johnson (NYSE: JNJ  )

*****

3.3%

Coca-Cola (NYSE: KO  )

****

3.4%

Abbott Labs (NYSE: ABT  )

****

3.6%

BP (NYSE: BP  )

*****

6.7%

United Parcel Service (NYSE: UPS  )

**

3.4%

Data from Motley Fool CAPS and Yahoo! Finance.

Once you've chosen a stock, you buy some. Let's say that you bought 200 shares of UPS at $52. You think that while it's unlikely to nosedive, it's not going to soar, either. Now you're going to boost your income stream by writing covered calls on it. You can write two calls -- each option covers 100 shares -- that give someone the right to buy the stock from you at $60 between now and mid-January. Right now, they would pay you $1.15 per share for writing those calls.

So what could happen? There are three possibilities:

  • The stock soars. UPS takes off and goes way over $60, and someone exercises the calls. UPS might be selling at $75 in January, but your profits would be limited to the $8 per share from the sale, plus the $1.15 per share you got for the calls, plus any dividends you might collect between now and then. That's still a better-than-19% return in five months, which isn't shabby at all on a large-cap dividend stock.
  • The stock tanks. Well, that's a risk with any stock. But you still made that $1.15 a share, and you can write two more calls after those expire in January.
  • The stock is stable. So you held a stable stock during a period of market volatility, collected a dividend, and made an extra $1.15 a share with your calls, which won't be exercised, and you can write another set for another buck or so a share in January.

The worst risk here -- aside from the inherent risk of owning the stock you choose -- is that you miss some of the upside if the stock takes off. But if you think the stock is going to take off, it's not a candidate for a covered call strategy.

Huh. I didn't realize that you could use options that way.

Yeah, a lot of people don't. But it's a low-risk way to add some extra income no matter what the market does, and, like I said, that seems like a good idea right now. And you're not competing head-to-head with some supercomputer at Goldman when you do this, either.

And that's just the beginning -- Jeff Fischer has created a video series on options investing. If you’d like to learn more about how to put options to work in your portfolio, simply enter your email address in the box below for free access.

Fool contributor John Rosevear owns shares of BP. Coca-Cola is a Motley Fool Inside Value selection. Johnson & Johnson, Coca-Cola, and United Parcel Service are Motley Fool Income Investor recommendations. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (36)

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 August 18, 2009, at 3:32 PM, noryakerson wrote:

    Learning about options makes me as giddy as I was in the early 90's when I was first started learning about dollar cost averaging and the power of compounding. Done right, options are big, big medicine for the little investor.

  • Report this Comment On August 18, 2009, at 8:44 PM, memoandstitch wrote:

    The car I sold you cannot get 40 mpg? I can sell you hydrogenated synthetic fuel that will boost your mpg to 60.

  • Report this Comment On August 19, 2009, at 10:04 AM, Crosshair wrote:

    The articles put forth by the Motley Fool in the past exposing the dangers (risks) of investing in options have not been discredited by Jeff Fisher's video series; they're still valid and should make you think twice before buying puts and calls. Options, by their very nature, offer a tremendous amount of leverage which can severely magnify your losses. Admittedly, options can generate income in flat markets and allow you to profit from volatility, but for the risk they pose, I'd these on the shelf.

    If you're considering using options, ensure you limit your exposure to less than 5-10% of your portfolio. Should your newly acquired positions appreciate, you stand to make a handsome. If the bets go against you, you're at least not out of the game completely.

    This whole shift in the way the Motley Fool thinks about options resembles those funny articles they put up on April Fool's Day. I just hope they come out soon to admit they've fooled everyone - once again.

  • Report this Comment On August 19, 2009, at 11:43 AM, bucheron wrote:

    ever heard of bonds?

  • Report this Comment On August 19, 2009, at 11:49 AM, TMFMarlowe wrote:

    Crosshair: I think that's oversimplistic. You'd do well to check out these videos -- options, done right, can lower your portfolio's overall risk profile. I think it's totally consistent with what the Fool's about -- educating and enriching. Take another look at what I wrote above. Where's the "tremendous amount of leverage" or risk in a covered-call strategy?

    bucheron: Yes. But in a crisis, all correlations tend to go to 1, and nonstandard approaches are sometimes the most useful. I like having a lot of tools in my toolbox.

    Thanks for reading.

    John Rosevear

  • Report this Comment On August 19, 2009, at 12:09 PM, pondee619 wrote:

    <i>But if you think the stock is going to take off, it's not a candidate for a covered call strategy.</i>

    But if I KNEW what a stock was going to do, I wouldn't need any strategies.

    In the example above, getting $61.15 a share plus dividends is not getting $75 plus those same dividends. You can kick yourself mighty hard missing $13.85 in lost profits.

    <i>That's still a better-than-19% return in five months, which isn't shabby at all on a large-cap dividend stock.</i> It is when you just missed 44%. This is what the covered call writer must over come. It ain't easy. Missing the large gains also SEEMS to happen with frightening regularity when you are writing.

  • Report this Comment On August 19, 2009, at 12:17 PM, Crosshair wrote:

    Let's take a look at when optionseducation.org advises a covered call option be used:

    "Though the covered call can be utilized in any market condition, it is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience little range over the lifetime of the call contract. The investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value."

    When has the Motley Fool cared about how Mr. Market values stocks in the short run? For good reason, it taught us to ignore market gyrations and instead focus on finding strong companies with enduring competitive advantages selling at attractive prices. If you believe the market will "experience little range over the lifetime of the call contract", you are no longer deemed an investor. You've now entered the world of speculators and, as such, are no longer distinguishable from those sitting at the craps table.

    As for educational material, I'd suggest you re-read Chapter 8 of Benjamin Graham's, The Intelligent Investor, "The Investor and Market Fluctuations". This chapter will you serve you better than Motley Fool's options video series.

    Crosshair

  • Report this Comment On August 19, 2009, at 1:58 PM, plange01 wrote:

    this is a traders market.buy and hold is fine but over the next few years you will be lucky you break even .your stock will just go up and down and look like a saw blade when seen on a chart.even the most famous invester warren buffett has had to alter his style he has his long term holdings collecting dividends and make his income through special deals on fixed income as seen in his lending of money to gs and hog then its credit default swaps ,derivitives,insurance companys he owns outright and trades..

  • Report this Comment On August 19, 2009, at 2:07 PM, RaulChapin wrote:

    John I think the biggest beef we all have is not with options per se, but with the way they are being promoted by the Fool. The promotion seems too eager to show that options are for everyone and that they are pretty harmless. The reality is that options are for a few people and they can be harmful. Here are some scenarios and don't forget, they can all be combined to add to the pain.

    a) The investor writes a covered call for a relatively safe stock, say Citigroup (as it appeared to many before it imploded), Citigroup then goes to $3 a share (as it did)

    The writer has lost a very sizable amount, and being an honest individual did not decide to sell his underlying stock and just go naked.

    b) Same case as above, except the investor panics and sells City going naked thinking this stock is going to zero, my call will never be exercised and I can not afford to keep losing. He goes naked in March 09 and decides to stay naked through the bear rally that ensues since. He lost on the way down, panicked and now is on the hook on the way up… if God forbid the rally were to continue while he waits for sense to come back to mister market ant the call gets exercised… he is in big trouble. Sure the rally has been relatively slow, but it could have been faster thus making this scenario likelier.

    c)The investor has many good calls, he keeps making 19% per year with this part of his portfolio, but the boring part of it is barely returning 7%, he gets very greedy, slowly his options strategy takes 80% of his portfolio, or 95% or 100% , now what was meant to be a marginal strategy becomes all of his portfolio, something as simple as those covered calls can keep him from being able to stop his losses

    d) Like with a credit card, that charges you no interest for 30 days as long as you pay it in full every month. It is a great way of boosting your finances (you basically have a free loan for the total of a months expenses, this can mean money in the bank generating interest etc). They are good… but yet so many people have to force themselves to go to cash only after they destroy their finances through credit card misuse. Covered calls are good, naked calls are not, going from one to the other might be a much easier choice than going from nothing to naked calls.

    Now don’t get me wrong, I get the point of the Fool, I have been burned with mismanaging my credit card before and now I pay in full every month, paying no interest, getting rewards and an interest free loan, so the tool is not bad as long as you can be disciplined with it (or you have been burned and now know how to avoid temptation ). Similarly I understand that what the Fool used to present as the biggest no no’s had to do with buying options while now it advocates selling them, which makes sense… if insurance is a racket, don’t buy it, but if you can, do sell it!! Also, there are times when an investor might need insurance for the short term in the form of options, for example:

    A high income individual is afraid that if the company he works for does not make it past a risky period of time, he will have a hard time finding a job, perhaps beyond the 6 months cash cushion he has. He can sell some of his portfolio now to increase his cushion, but that would have many costs (Realizing profits, selling at a low point, taking out of a tax shelter, commissions etc) alternatively he can decide on what part of his portfolio he would sell if his fears were realized, he then buys puts on those shares and continues to hold them. If he is jobless and his cash cushion disappears, he can sell the stock through the put option at the price at which he originally decided to sell (or higher if the stock has gone up instead), but if things are not as tough as he imagined, then he was able to keep his portfolio where he wanted to have it, and the options served the purpose of insurance. He eliminated the down side of his particular situation through the sensible use of options (even buying them in this case and knowing fully well that he was unlikely to have to use them)

  • Report this Comment On August 19, 2009, at 2:24 PM, TMFMarlowe wrote:

    RaulChapin, thanks for the thoughtful comment. FWIW, my background is in retirement stuff -- I'll be (and have been) the first one to say that options are not something to use without care and education and discipline. If the Fool can provide the second while strongly encouraging the rest -- and from what I've seen so far of the service and of Jeff's other work, I think they're on the right track -- then I think this options service can provide a valuable set of tools for the prudent investor to have in his or her toolbox. That's where I'm coming from, as a writer and as an individual investor, and that's the point I tried to make in this article. Your hypotheticals, while well taken, assume that the investor gets greedy and/or panics, deviates from plan, and screws up.

    But... you can lose plenty of money doing that with nothing but long positions in stocks, and in the last year an awful lot of people have. We fight those tendencies by providing education, right? Is this really all that different?

    Thanks for reading.

    John Rosevear

  • Report this Comment On October 13, 2009, at 6:10 PM, DLukes wrote:

    My comment relates to the marketing of the service rather than its usefullness. Breathlessly limiting the sign-up period to "62 hours only!" and sending the typical 3 page come-on with lots of light but little heat--hardly seems very Foolish. This is being done with more than one of your services.

    I've been impressed over many years with The Fool's credibility. It's a shame to see that credibility being undermined by the Fool itself.

    Please consider this a constructive comment.

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