Options: A Foolish Introduction

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 around here, was not a fan of small individual investors using 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. optionsXpress Holdings (Nasdaq: OXPS  ) is a Motley Fool Stock Advisor recommendation. 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 made fortunes in the option markets.

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 Wal-Mart (NYSE: WMT  ) , which has gone nowhere for years? Why not regularly write call options against your shares to produce an income stream? (Mystified by the terminology? Keep reading. We'll clear things up in subsequent articles.)

Concerned that Research In Motion (Nasdaq: RIMM  ) may continue falling, given the news that the SEC has expanded its investigation into the company's past stock-option-granting practices? You might consider buying a put option, which could protect your current profits if the stock subsequently tanks.

Believe that Microsoft (Nasdaq: MSFT  ) is mind-numbingly cheap in the face of pending Vista-related upgrades? Instead of buying shares, you could magnify your gains 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 an underlying "something else." Before you start using options, it's Foolish to make sure you understand exactly what that "something" is.

For years, Warren Buffett has warned investors about the potential dire consequences of unchecked and growing derivatives use in capital markets. Then again, the Oracle of Omaha himself has used derivatives when he feels the market's offering him a value opportunity; he mentioned doing exactly that in his most recent letter to shareholders.

We Fools believe that 99% of individual retail investors -- that's you, folks -- 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 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? Let's get started:

If you are interested in receiving more information from The Motley Fool about investing in options, please click here.

Fool contributor Jim Gillies owns no shares of any company mentioned. Wal-Mart and Microsoft are Motley Fool Inside Value picks. The Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (278)

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 October 29, 2008, at 2:42 PM, jingoism wrote:

    Two years wouldn't be a long time frame for even the worst of recessions over the past 60 years to get better. Each one is the worst, ever; but then it tends to end with the among the best markets, ever.

    Meanwhile, my options gambits really have not paid off. I'm all "invested" in call options - no stocks. Is that investing, or gambling? I'd say half-way in between. Whatever someone does, they shouldn't invest all they have, in options.

    From when I bought in, my March '09 call option on Albemarle Co is down 85%, Valueclick down 90%, Sirius stable (from when I bought it) but probably not headed up by then, CDC Corp (CHINA) down 70% with some chance of going up by then, VDSI down 60%.

    From date of puchase, my January '10 calls are down, too: CDC Corp down 60% (chance of going back up by then), AMAT $17.50 call down 60%, Wyeth $40 call down 75%, and on down the list.

    The calls expiring in January, 2010 have a good chance of bouncing back up by then. If they don't, they expire worthless.

    I have some AMAT (Applied Materials) $12.50 call options expiring in January, 2011, and these are only up 3%, so far, from when I bought them. The way options work, if only these pay off, I could make up for complete loss through expiration of all the other calls.

    Meanwhile, I feel like one of the passengers on a troubled ship; I have to look at the total situation to realize it will probably not go down like the Titanic. That's how I feel, like I am really having to be philosohpical about things to keep cool enough about it all.

    Fortunately, I didn't invest everything I own in the call options; possibly, I will feel, in retrospect, to be vindicated, if something pays off by January, 2011. However, were I not investing my own money, I would have been fired, by now.

  • Report this Comment On December 07, 2008, at 6:26 PM, NotJesseL wrote:

    This is a crazy market. Traders can make money and investors can lose money far more easily than normal. Higher volatility makes options more valuable all other things being equal. Long term options (like the January 2011 call ) are likely to be losers because the time value of the call is going to be high. To win in options you have to have 3 things right, the direction, the target price and the time this is going to happen. With stocks, you can afford to be patient.

  • Report this Comment On December 12, 2008, at 5:46 PM, Padre3210 wrote:

    Jingoism, please get out of those options! They are the worst buy-and-hold investment in history! You need to put the fact that they expire to WORK for you. For example, I have never seen an environment where near the money options, 1 month out can go for 20% of the stock price. But, they are everywhere now! So, when options get expensive, what do you do? You don't buy them. You SELL them!

    Example, discussion here of BIDU. Beaten down, lots of upside. No one knows when. Not that much downside. Buy 100 BIDU at 114, spend $11,400. Sell covered calls that let the option holder buy your shares at 125 by Jan 16. Receive 9.50 for them (8.33%). Come January, they either expire, and you keep the 8.3%, and do it again next month (12 x 8.3% = 99%/year!) OR they "call the shares" in which case you get 9.50 plus you sell your 114 shares for 125! Return? (125-114)+9.50=20.5/114, or 18%. Not bad for less than 30 days. Even if BIDU drops a little further, how can you go wrong, doing this? Look for stocks with expensive options, that seem near bottoms (support), and THAT is how you'll make money in options!

  • Report this Comment On December 22, 2008, at 3:28 AM, apawling wrote:

    Padre 3210 has hit the nail on the head. I don't recommend buying call options at all. Selling covered options, specifically at or above cost basis is a great way to help your returns in this market.

    I would add that if you want to really cover yourself against downside, sell out of the money puts instead of buying a stock outright.

    For example: a company I like, COP is trading around 50, sell a feb put at 40 at about 1.60 and keep the cash to cover it in short term treasuries (2-3% return annually) If the stock drops 20% plus in 2 months you buy it at 20% discount and you just bought a Warren Buffett stock at significantly lower than his cost basis (and can sell calls on it) if it doesn't you can do it all over again and make about 2% per month- plus the treasury return. That's about 25% a year- with (and this is key) very significant downside protection to boot.

    The trade off is if the stock takes off you might miss some upside - for me its a good deal to get "equity like" returns and protection from the initial 20% of downside in the bargain.

    Bottom line - the stock market prices options as if a good company selling cheap is risky. If you disagree and think the time to buy good stocks is when they are on sale then options can really work to your advantage,

    Best of all- most option markets on stocks are much too small and illiquid for big investors - its an area where the little guy can really take advantage of a good thing!

  • Report this Comment On February 16, 2009, at 1:53 AM, covercalls wrote:

    It is really foolish to buy options, except to close a open position is a suckers game in the long run. Granted there are few option buying traders out there that are successful and can make money, but my money is on the sellers of calls and puts. I've been trading in the options market since 1991 (thus my ID as COVERCALLS) and I specialize in selling near month options so I do have a bit of experience in the options world. At least 4 out of 5 out-of-money options I write expire worthless. Due to the recent down turn I have accepted work to restore financial stability to many IRAs and Roth IRAs and other trading accounts that had lost 50% or more. My plan is to sell options in the leveraged ETFs (Exchange Traded Funds) market. Trading ETFs has allowed the IRAs to essential short the market. So I can trade both sides of the fence. Since taking over these accounts, results have been very promising and if the trend continues, I should have their accounts back in the black in about 3 years.

  • Report this Comment On June 11, 2009, at 12:01 PM, TMFFischer wrote:

    Indeed, writing (or selling) options is the best strategy for using them in most cases. You're paid upfront to write an option and the time value of options works strictly in your favor. If most investors lose money buying options, most investors make money writing them (and for many years, I've found this true). They're a great tool when you know how to use them.

  • Report this Comment On December 15, 2009, at 5:37 PM, lennysims wrote:

    I want to join the motley fool options, but my account has not yet been approved--I'm just not rich enough yet.

  • Report this Comment On January 07, 2011, at 9:36 PM, superx1 wrote:

    "Microsoft mind-numbingly cheap because of Vista upgrades."

    Funny stuff. The stock was trading around $30.00 when the article was written. It spiked briefly to $37.00 about 7 months later, and spent 2008 going downhill after the Vista upgrades, before collapsing to $16.15 in early 2009.

    As at January 7, 2011, it's trading at $28.60, and it hasn't broken $31.10 in over 3 years.

    But that’s not even the best part. The author characterizes a stock as "mind-numbingly cheap" when it was actually at a 5 year high: it had not previously reached the level it was at in March of 2007 since February 2002. He might as well have said "mind-numbingly expensive."

    One wonders if the author ever even looked at a chart before he started writing. Hell, maybe he’s an analyst!

  • Report this Comment On March 19, 2012, at 6:21 PM, 540Lyle wrote:

    superx1,

    Re: "Microsoft mind-numbingly cheap because of Vista upgrades"

    Does this not further articulate how buying a call of MS at the time of this article may have been a better option than buying the stock outright? Thus, the loss would have only been the option premium and one would have been holding the remaining difference in cash during the downturn.

    Secondly, one could have been buying puts while the price fell and then buying calls while the stock began to return. At the time, the stock was probably "cheap" by analyst opinions.

    Perhaps you can point out 5 stocks today that are relatively "Cheap" and we'll see how it fairs in the next 18 months.

    A wise man knows he's a fool.

  • Report this Comment On July 01, 2013, at 1:16 AM, nutsandbolts13 wrote:

    I like your website and the services and information it provides. However, I am offended by the type of pitch your Motley chief technician used to sell one of your products. He did get my attention by making the case for investing in a fabulous growth company he was investing in which he would reveal at the close of his presentation. But in the end, instead of disclosing the name of this company, trying to convince the viewer ( and foolish me) to take out a suscription to a Rules Breaker newsletter What this type of pitch accomplished was to turn me off You have good products and services and don't need to treat your customer like a doofus.

  • Report this Comment On June 10, 2014, at 8:15 PM, sep7501 wrote:
  • Report this Comment On June 10, 2014, at 8:16 PM, sep7501 wrote:

    sorry last post should have provided a hyperlink for the article. but there's tons of info about trading options and it's easy to read and understand. http://voices.yahoo.com/the-basics-options-trading-12670711....

  • Report this Comment On October 13, 2014, at 11:02 PM, Fabin81 wrote:

    lets say I have $100,000 worth of Crap Company. When the market tanks I lose 90% of that stock. It will take many years if ever to get that money back. But lets say I have $2000 worth of call options that controls $100,000 worth of shares on that Crap Company. All I can lose is $2000. So there are pluses and minuses to options and stocks. But the fool just mostly prefers to long stocks.

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