In the movie Two for the Money, Matthew McConaughey plays a hotshot sports bookie with an uncanny knack for picking the winning team. But his picks eventually go south, leaving his clients understandably angry. One desperate client ends up calling him from a desolate phone booth, screaming, "I had a life!"
Consider this fair warning, Fool. There's a valid case, if not necessarily a Foolish one, for employing call options as part of your overall portfolio. But if you make options the core of your investing strategy, that guy in the phone booth could be you.
Options are a type of derivative. That means you're not actually buying securities -- just a contract that gives you the option to acquire a security at a specified price for a specified period of time. In investing, it's important to remember that you should never stake "what you have and need for what you want." Option money has to be money that you're prepared to lose, because that's a likely outcome. Most of the time, options don't work.
Know your risks
There are three somewhat formidable hurdles to overcome when using options: time, direction, and magnitude. The Fool's options FAQ does a good job of outlining all three.
Time means that options have finite lifespans. When you buy a stock, you can ride out the roller coaster as it dips lower, then hopefully ramps higher. When buying a call option, the roller coaster can be taken right out from under you. As options creep (more like sprint, if you're holding them) closer to expiration, time premium is lost, and the option loses value. After expiration, they cease to exist altogether.
Direction is fairly obvious. You buy a "call" option to speculate that a stock price will go up past a certain price -- the "strike price." If it goes down, or generally moves sideways, your option usually expires, leaving you with nothing to show for it.
Magnitude is a little more complex, but it basically entails knowing how much a stock will rise when buying a call. To win with call options, you have to correctly predict time, direction and magnitude -- a tall order in a world where picking equities is hard enough.
Even Warren Buffett has called the use of derivatives "toxic." Indeed, the majority of Fools recommend avoiding options, especially for beginning investors.
The right time for options
But suppose you really want to participate in an idea -- for example, an upstart drug company, or a manufacturing company whose small product could be picked up by major retailers. If that drug company does not plug its pipeline, or big retailers decide to duplicate the product rather than stocking the original, disaster could strike, and shares might plummet. In investing parlance, these black-and-white situations are usually referred to as binary outcomes. They work -- "one" -- or they don't -- "zero." As Buffett says, anything times zero is, well, zero!
If that zero outcome is too much to bear, but you think the stock might really go up, you could consider buying a call option. It'd let you participate in the upside while limiting the potential downside. Buying options allows you to amplify your payoffs while clearly defining your losses.
Let's take the example of that one-hit-wonder drug company. Suppose it's currently trading at $10 per share, with a chance to go to $20 if the FDA blesses its promising new product. So you buy an option that costs $2, expires in one year, and has a strike price of $10. Lo and behold, the drug gets approved, and the stock shoots up to the top end of your expectations. Your profit would be the stock price of $20, less the strike price of $10 and the $2 purchase price for the option. Commission charges aside, you'd snag a profit of $8 per share. (To simplify this example, I'm dealing with single options, but you should know that they're generally sold in lots of 100.)
We'll start with the obvious question: If there are so many potential pitfalls involved with options, why use them at all? If the underlying price of a security rises beyond the strike price, couldn't you have made a greater profit by actually owning the stock anyway? Yes, absolutely -- if you had bought the stock, you could have reaped $10 in profit instead of $8.
But consider this. Owning a stock requires you to risk more capital to get a payoff. In the case of the call option, you risked $2 to make $8 -- a 300% profit. Had you bought the stock outright, you would have needed $10 to make another $10 -- a 100% profit. While you would have made more money buying the stock, you'd have had to risk disproportionately more of your capital to do so. Buying calls allows you to risk someone else's capital; in return, however, you risk time, magnitude and direction.
Real-world options
The credit markets are going through an upheaval that the CFO of Bear Stearns (NYSE: BSC) has dubbed as bad as Internet bubble of 2001 or the 1998 downfall of Long-Term Capital Management. This may create a situation where you don't want to own REITs or financials outright, but don't want to entirely sit on the sidelines, either. If the storm blows over in the next few months, the picture will be far clearer for banks like Citigroup (NYSE: C), mortgage names like Countrywide Financial (NYSE: CFC), and REITs like Northstar (NYSE: NRF) or Deerfield Triarc Capital (NYSE: DFR). While their situations may be too uncertain to load up on these securities, options may provide a potentially lucrative participatory route.
Again, don't be the guy in that phone booth! Approach options with caution, and if you don't understand the risks, stay away entirely. However, if you can appreciate and respect the power of this commonplace derivative, it can prove a valuable tool in creating disproportionately powerful payoffs in the public marketplace.
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Fool contributor Rimmy Malhotra is a New York City-based money manager. He does not own shares in any of the companies mentioned. He welcomes your feedback. The Fool's disclosure policy likes Santa's Little Helper at 3 to 1.
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