Are Options an Option?

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." When you buy options, the money you spend has to be money that you're prepared to lose, because that's a likely outcome. Often, buying options doesn't work.

Know your risks
There are three somewhat formidable hurdles to overcome when using options: time, direction, and magnitude.

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, options can be a potential minefield for beginning investors who don't understand the risks involved.

The right time for options
But there are situations in which using options makes sense. For instance, 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
Certainly, there are plenty of ways you could have made money by owning options over the past nine months. Here are just a few:

  • The recovery in financials like Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and Goldman Sachs (NYSE: GS  ) created huge gains for shareholders, but even larger ones for buyers of options.
  • Similarly, while many were betting that casino stocks such as MGM Mirage (NYSE: MGM  ) , Wynn Resorts (Nasdaq: WYNN  ) , and Las Vegas Sands (NYSE: LVS  ) would go into bankruptcy, investors who bought call options laughed all the way to the bank.
  • Technology names such as Google (Nasdaq: GOOG  ) have seen some impressive gains this year. But while Google shares are expensive, options let investors get in with much less capital -- and their gains have been even bigger in some cases.

For many investors, the situations these companies faced made them too risky to buy shares. But by buying options, investors stayed in the game, limiting their downside but providing 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.

Now's a great time to learn more about options. Our Motley Fool Options team offers a hands-on approach to options investing that will help you get smarter, make money, and have fun along the way. Want to learn more? Just put your email in the box below.

This article, written by Rimmy Malhotra, was originally published Aug. 8, 2007. It has been updated by Dan Caplinger, who doesn't own shares in any of the companies mentioned. Google is a Motley Fool Rule Breakers recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy likes Santa's Little Helper at 3-to-1.


Read/Post Comments (9) | Recommend This Article (5)

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 December 10, 2009, at 5:27 PM, Archvile wrote:

    You only explained what would happen IF the stock made it to @20. Would have been helpful if you also illustrated what one would lose if the stock did not make the $20 at the end of the year.

  • Report this Comment On December 10, 2009, at 5:45 PM, RobertC314 wrote:

    If the stock is below $10 then you lose your $2. If the stock is above $10 then you gain (Stock Price - $12). The twelve is the $10 strike price plus the amount you paid for the option.

    Thus if the stock:

    Went to $40 then you would have made $28

    Went to $15 then you would have made $3.

    Went to $12 then you would have broken even

    Went to $11 then you would have lost $1

    Went to $10 then you would have lost $2

    Went to $7 then you would have lost $2

    Went to $0 then you would have lost $2

  • Report this Comment On December 10, 2009, at 10:30 PM, dtarends wrote:

    RobertC314 has once again shown his extensive understanding of options and has explained what can happen under different scenarios. Here is another point to consider. Option prices represent the collective knowledge of the market. If there is a good reason to expect a stock to rise, the price of call options will be high. Conversely, if a stock seems due for a correction, the price of put options will increase. The idea that you could buy a cheap option and hit a home run is a long shot at best. Most options expire worthless, which would give support to the idea of writing them, not buying them.

  • Report this Comment On December 10, 2009, at 10:31 PM, dtarends wrote:

    RobertC314 has once again shown his extensive understanding of options and has explained what can happen under different scenarios. Here is another point to consider. Option prices represent the collective knowledge of the market. If there is a good reason to expect a stock to rise, the price of call options will be high. Conversely, if a stock seems due for a correction, the price of put options will increase. The idea that you could buy a cheap option and hit a home run is a long shot at best. Most options expire worthless, which would give support to the idea of writing them, not buying them.

  • Report this Comment On December 11, 2009, at 5:09 PM, gkuep1945 wrote:

    One thing I am not understanding about options. (Probably need to read more.) If the stock for a call option goes up and I can profit from the option, is the process of completing the call, buying the stock at the lower price and selling the stock at the higher price all performed automatically at my broker? Or are these all separate functions and have the settlement delay between each? I don't understand the timing of these.

  • Report this Comment On December 14, 2009, at 7:04 AM, dmkap wrote:

    As the price of the stock goes up, so does the price of the option. In the above example, if the stock reaches $20, then the value of the option will be (at least) $8. Any time before expiration, you can simply sell the option at its current price, and take the gain. If you wait for option expiration, then your broker will automatically "exercise" your option for you (unless you tell him otherwise, in advance) - meaning he will buy 100 shares of the stock for every call option you own, but will NOT sell it for you automatically. You will simply own 100 shares of the stock, at a cost of $10 per share. You can then sell the stock on the open market any time you want.

  • Report this Comment On February 19, 2012, at 2:53 AM, TradeOpus wrote:

    Why Trade Binary Options?

    In today’s financial markets, if someone wants to invest in an underlying asset, the investor has a few choices. The first and simplest choice is that of purchasing the underlying asset through one of the financial markets. This is the most capital intensive options as the investor must put up the money for the asset. There is a second way to invest in the underlying asset and that is to buy or sell options that trade in financial markets. This may be inconvenient and take time. There is another avenue that exists to allow the investor to invest in the movement of stocks. These are called Binary Options.

    A Binary Option is a method of profiting from the movement in stocks without having to finance the purchase of that stock. A Binary Option has two possible outcomes (thus binary). The investor will either make a predetermined percentage profit or will lose the investment completely. There are two basic forms of Binary Options. There are “call options“, for the investor who anticipates that the underlying asset will move up, and “put options“, for the investor who thinks the underlying asset price will move lower. Binary Options may be a risky investment tool, but they provide high reward. The clearest way to understand the value of a binary options trade is to compare it with a straight equity purchase and a conventional option trade.

    Variables:

    We are trading stock / options in Disney (“DIS”)

    At 2:00 PM DIS shares are trading at $39.00 a share.

    A $100 investment will be used for these examples.

    Stock Purchase:

    With $100.00 you could by approximately 2.5 shares of DIS. You would own the stock at a base price of $39.00 as the stock rises you make money as it goes down you lose money. The straight stock purchase has the least risk. The stock would have to go to $0 to lose your entire investment. You could also sell the stock at any point to minimize your loss. Of course to make 70% on your investment DIS would have to trade at $67.00. This could take a long period of time or may never happen at all.

    Conventional Option Trade:

    A short term call option with expiration date in 3 weeks and strike price of $39.00 costs about $1.00 per contract of 100 shares, so for $100 you could by 1 contract and control 100 shares for 3 weeks. In the conventional option trade the stock would have to go up more than $1 in the 3 week period in order to generate profit. If the stock closes below $39 at the expiration date than you lose your $100.00 investment. In order to make the same 70% return the stock would have to trade at $40.70 at some point before the expiration date. Two factors mitigate the risk. The option itself is trade-able before the expiration date and you can exercise the option at any time before expiration.

    Binary Option Trade:

    The investor purchases a Binary Option Call at a spot price of $39.00. The option expires at 2:30 PM. If DIS is trading above $39.00 at 2:30 you make $70 on the trade in minutes! If DIS is below $39.00 at 2:30 you lose your $100 investment.

    Conclusion:

    The Binary Option trade carries the highest short term reward. A return of 70% on your investment in a half hour. The trade off for this high reward is the risk of losing your $100 investment in the same period if the stock does not go above $39.00.

  • Report this Comment On August 04, 2014, at 5:13 PM, Bsyldy41 wrote:

    When you buy options - I thought there was a way that you could buy based on rising or lowering to minimize loss. I thought that you could buy based on the price going up AND buy in case it goes down as well. Is there a way to invest to insure some sort of gain regardless of the movement of prices on an investment?

  • Report this Comment On October 13, 2014, at 12:22 PM, blueghost wrote:

    Here's a trade in options called a "straddle" I have used successfully to make small amounts, sometimes in one day: With low volatility buy a put and a call at the same strike price. Have your broker fish for good fills, ie below published option prices done separately.

    Upon setting the straddle, go ahead and offer the options at some price that yields say, one percent profit (above fees). A broker may be able to make this happen the same day!

    Choose stocks that exhibit price fluctuations that would exceed the cost of both options during the life time of the options, providing evidence volatility will return. John

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1064166, ~/Articles/ArticleHandler.aspx, 10/24/2014 7:23:52 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement