A Strategy You Should Consider

With the explosion of option use in recent years, you may be asking yourself, "What are options, and why would anyone consider using them?"

Options represent the right (but not the obligation) to take some sort of action -- buying or selling shares of a given stock -- by a predetermined date.

There are two types of options: calls and puts. And there are two sides to every option transaction -- the party buying the option, and the party selling (also called writing) the option. Each side comes with its own risk/reward profile, and each may be entered into for different strategic reasons.

What's a call option?
A call is the option to buy the underlying stock at a predetermined price (the strike price) by a predetermined date (the expiry). The buyer of a call has the right to buy shares at the strike price until expiry. If the call buyer decides to buy -- also known as exercising the option -- the call writer is obliged to sell his/her shares to the call buyer at the strike price.

Cisco (Nasdaq: CSCO  ) , for example, recently fell close to 20% in a week after its most recent earnings expectations were "less awesome" than the market was pricing in. But the company is still the king of network equipment and not likely to relinquish that position any time soon. An investor believing that the fall was overdone and that future quarters will see a reversal of this sudden pessimism could leverage potential gains by buying a call option with a strike price at $20, expiring in January 2013.

Today, that call would cost around $400 per 100 shares, or $4.00 per share. The call buyer has the right to exercise that option anytime between now and Jan. 18, 2013, to buy shares of the networking colossus for $20. The writer of the call would have the obligation to deliver those shares and be happy receiving $20 for them. We'll discuss the merits and motivations of each side of the trade momentarily.

What's a put option?
If a call is the right to buy, then perhaps unsurprisingly, a put is the option to sell the underlying stock at a predetermined strike price until a fixed expiration date. The put buyer has the right to sell shares at the strike price, and if he/she decides to sell, the put writer is obliged to buy at that price.

Perhaps you view the recent Federal Reserve proposal to limit debit-card interchange fees as a harbinger of serious profitability declines for card providers like Visa (NYSE: V  ) . Investors could profit from a potential slide in the share price by buying a put option at, say, the $70 strike price. The buyer of the put has the right, until expiry, to sell his or her shares for $70. Sellers of the put have the obligation to purchase the shares for $70 (which could hurt, in the event that Visa were to decline severely).

Why use options?
Call buyers profit when the price of the underlying shares rises, since the call price will rise as the shares do. Call writers are making the opposite bet, hoping for stock price declines (or, at least for the stock to rise less than the amount they receive for selling the call in the first place).

Put buyers profit when the underlying stock price falls, because the put price increases as the underlying stock price decreases. Conversely, put writers are hoping for the option to expire with the stock price above the strike price, or at least for the stock to decline by an amount less than what they've been paid to sell the put.

You certainly don't need options to make money in the stock market, but there are several reasons why you may want to consider using them. Calls and puts -- alone, combined with each other, or even in addition to positions in the underlying stock -- can provide various levels of leverage or protection to a portfolio.

  • Options can act as insurance to protect gains: Presumed left-for-dead footware fad Crocs (Nasdaq: CROX  ) has tripled in 2010. If you're not convinced that the resurrected rubber shoe purveyor can maintain its recent success, buying a put option can lock in your gains (minus the cost of the put, of course).
  • Options can help investors get cheaper entry prices for their stocks: Guess? (NYSE: GES  ) , in my view, is a quality company selling at a somewhat richer-than-I'd-like price tag. Instead of setting a limit order, you could sell puts on the stock. If the stock reaches the strike price and the put is executed, the put writer's net purchase price would be lower by the amount they collected. If it doesn't, the put writer pockets the amount of money for which the put was sold.
  • Options can be used to generate steady income from an underlying portfolio of blue-chip stocks: Take Microsoft (NYSE: MSFT  ) , a big, dominant, company, but one whose business is being chipped away at the margins. Microsoft's stock price has spent most of the last decade bouncing between $25 and $30. Long-term stock investors likely won't have much beyond a modest dividend to show for their patience. But a disciplined "buy-write" covered call strategy can enhance those anemic returns.
  • Or they can be employed in an attempt to double or triple your money almost overnight: This strategy's not for the faint of heart (or perhaps strong of brain). Still, buying calls on beaten-down small caps like Portfolio Recovery Associates (Nasdaq: PRAA  ) in February 2009 would have paid off handsomely.

But no matter how options are used, it's wise to always remember Robert A. Heinlein's acronym: TANSTAAFL (There Ain't No Such Thing as a Free Lunch). Insurance costs money -- money that comes out of your potential profits. Steady income comes at the cost of limiting the prospective upside of your investment. The chance for a quick double or triple has the accompanying risk of losing the money you paid for the option.

The Foolish bottom line
Remember: Calls are the right to buy a stock, and puts are the right to sell a stock. For every buyer of an option, there's a corresponding seller. Different option users may be employing different strategies.

To learn more about the profitable options strategies we've been using in real-money portfolios for years, simply enter your email address in the box below to receive information about Motley Fool Pro, plus a free report with all the details on how you can begin putting three wealth-building strategies to work in your own portfolio.

This article was originally published July 30, 2009. It has been updated.

Jim Gillies owns shares of Portfolio Recovery Associates and long-term call options on Cisco. Microsoft is a Motley Fool Inside Value pick. Portfolio Recovery Associates is a Motley Fool Hidden Gems recommendation. The Fool has created a bull call spread position on Cisco Systems. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Guess?, and Microsoft. Motley Fool Alpha owns shares of Cisco Systems. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (12)

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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 December 29, 2010, at 11:12 PM, 123spot wrote:

    This is the first time I have really understood options, despite reading at least 30 explanations. You are a good teacher. "Tell 'em what you're going to tell the, tell 'em, then tell 'em what you told 'em". Thank you. Cheers.

  • Report this Comment On December 30, 2010, at 9:21 AM, BillyThrottle wrote:

    Same here 123spot. Great article.

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