Abraham Maslow once said, "When the only tool you have is a hammer, it is tempting to treat everything as if it were a nail."
Just about a year ago, as we continued to struggle with the aftermath of a financial meltdown and a decidedly pessimistic stock market, I looked at the landscape of deeply discounted stocks and made this bold prediction: The U.S. markets and economy would rebound from the mess we were in.
OK, so it wasn't that bold. And I figured if I were wrong, we'd all have bigger problems to deal with. So I took out my trusty hammer and started driving nails.
I purchased two-year call options -- LEAPS -- on stocks that were not only significantly depressed, but whose options weren't pricing in significant gains. LEAPS are bets that a particular stock will be higher (calls) or lower (puts) in a year or two.
I started with Goldman Sachs (NYSE: GS ) , which at the time seemed well-positioned inside and outside the government to succeed … nail! I saw Red Hat (NYSE: RHT ) continuing to benefit from a move to open source software … nail! Cemex (NYSE: CX ) , a global leader in cement, was certain to rally on worldwide infrastructure spending … nail! Western Union (NYSE: WU ) , with its growing international business … nail! Legg Mason (NYSE: LM ) … nail! Verizon (NYSE: VZ ) … nail! I was very close to adding Caterpillar (NYSE: CAT ) , but a coworker convinced me that there was more pain ahead for that stock.
By the time I had put the hammer down, I had purchased seven positions in the six stocks, all long-term call options set to expire in January 2011.
There's good news and bad news
Fast forward 10 months to mid-October. The value of the portfolio had quadrupled to create a gain of $100,000.
That was great -- except that the LEAPS still had 14 months until expiration, and new risks were emerging within the portfolio. Between October and November, the gain dropped by $30,000. All of a sudden, I was less worried about the market over the next 12 months, and more worried about how to protect my remaining gains.
As I looked in the toolbox and only saw that lonely hammer, it was painfully clear that I needed a more sophisticated options strategy if I wanted to truly manage my portfolio's risks.
Finding new tools
Fortunately, I have access to Jeff Fischer and the team at Motley Fool Options, which uses options to reduce volatility and generate income beyond what's available from solely buying the stocks.
With the help of Jeff and the team, and in front of the Options community, we analyzed each position, discussed multiple alternatives, and formulated a series of trades that met my objectives.
For instance, Jeff gently but convincingly persuaded me to close out my huge Goldman gain, arguing that it was all time value and could completely evaporate. After reading that I was planning to buy puts on Red Hat, he pointed out that I was risking resetting the long-term capital gains clock, even though I had held the calls for more than 10 months.
Jeff even abstained from chastising me for purchasing Verizon without a solid thesis, and then compounding the mistake by holding the option as they circled the drain. "At least you'll have something to offset some of your capital gains," he said, focusing on the bright side.
In the end, I had fewer but more strategic options investments, and less risk.
Along the way, I learned several lessons that are useful for anyone interested in options.
- It's the stock, stupid. To get the options trade right, you have to have a solid understanding of the underlying stock, as well as a working hypothesis about what that stock will do in the future. Not having a real investing thesis for Verizon led me to a 97% loss.
- Watch the time value. As the option gets closer to its expiration date, there's less opportunity for the investment to hit its strike price, so the value of the option declines.
- Expand the toolbox. For example, selling calls while owning the underlying stock can be a great way to generate a little immediate income -- or, if the stock drops, lower your cost basis. There are several other strategies that the Options team uses to minimize risk while focusing on great stocks.
I have been so impressed with the talent of the Motley Fool Options team that, for the month of January, I'll be taking my own money and investing in every recommendation they make. So if you're interested in options, and looking for the right opportunity to jump in, I invite you to join me as we get smarter, make money, and have fun on our way to a better investing experience.
If you'd like to learn more, just put your email in the box below.