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; 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) anytime 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 pipeline will prove more effective than a sugar pill and get bought up by the likes of Pfizer (NYSE: PFE  ) or Merck (NYSE: MRK  ) . 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 stocks that "everybody loved," like Sun Micro (Nasdaq: JAVA  ) or Dell (Nasdaq: DELL  ) (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 First Solar (Nasdaq: FSLR  ) , for example, which inspires a lot of passion among investors.  As something of an enviro-geek, I admire the company and what it's doing 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 First Solar. 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 First Solar's price falls.

If you already own First Solar and think that there are 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 First Solar'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 (NYSE: ALU  ) , JDS Uniphase, or Ballard Power, not to mention the recent performance of stocks like Citigroup or AIG (NYSE: 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-touted 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 additional income, or protecting their hard-won gains should seriously consider options, which can do all of that and more, and without necessarily adding additional risk.

If you're interested in learning how to use options appropriately in your own portfolio, check out what's going on at Motley Fool Options -- just enter your email in the box below for more information.

This article was originally published July 31, 2009. It has been updated.

Foolish analyst Jim Gillies owns none of the stocks mentioned here. Dell and Pfizer are Motley Fool Inside Value choices. First Solar is a Rule Breakers pick. The Motley Fool has a disclosure policy.


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