How Embracing Risk Can Make You Rich

Even though many investors see them as being both risky and extremely complicated, options can play an important role in a well-rounded investment portfolio. But in order to trade options successfully, you need to have a firm grasp of what makes certain stocks more attractive for options plays -- and which don't justify the risk involved.

Think from the sell side
For many investors, options are all about making a big score. Because you can buy options for much less than you'd pay for the same number of shares, buying options can help you gain a lot of leverage in your investing. If you pick the right option on the right stock, investing with options can give you gains that are tens or even hundreds of times bigger than what you'd earn simply by buying shares of stock. On the other hand, it's easy -- and even common -- for buyers of options to lose every penny of their investment.

But there's another, much different way to use options to enhance your overall investing strategy. By selling options, you accept an immediate payment in exchange for taking on the obligation to buy or sell shares in the future. As the options experts at Motley Fool Pro frequently discuss, sometimes that obligation is something you'd want to take on anyway -- and so what you receive for selling the option is just icing on the cake.

And when it comes to icing, my daughter has taught me a valuable lesson: There's no such thing as too much.

Why options are different
What you'll find, though, is that the amount you'll receive for selling options differs greatly from stock to stock. For instance, take a look at the current prices for call options on these stocks:

Stock

Recent Price

Call Option

Option Price

Option Price as %
of Stock Price

IBM (NYSE: IBM  )

126.12

Feb. $125

3.02

2.4%

American Express (NYSE: AXP  )

37.79

Feb. $38

1.30

3.4%

Las Vegas Sands (NYSE: LVS  )

16.19

Feb. $16

1.23

7.6%

Coca-Cola (NYSE: KO  )

54.35

Feb. $55

0.88

1.6%

Johnson & Johnson (NYSE: JNJ  )

63.22

Feb. $65

0.39

0.6%

ExxonMobil (NYSE: XOM  )

65.85

Feb. $65

1.71

2.6%

AT&T (NYSE: T  )

25.58

Feb. $26

0.45

1.8%

Source: Yahoo! Finance. As of Jan. 25 close.

Even though each of these call options expires next month and has a strike price that's pretty close to the current share price, there's a big disparity among what you'll get for selling options on various stocks.

Moreover, the difference isn't solely related to the range of share prices. You'd expect options on a $100-plus stock like IBM to be more costly than those on lower-priced shares like Las Vegas Sands. But as you can see, even on a percentage basis, there's a wide range.

Volatility and you
The key component to understanding option pricing is volatility. At its core, an option's value comes largely from the volatility of the underlying stock. Think about it: If a stock had no volatility at all and simply traded flat all the time, then options wouldn't serve any purpose. Investors would know with certainty the value of the stock, and so an option's value would be completely based on the difference between the option's strike price and the market price of the shares.

On the other hand, highly volatile stocks make options more valuable. Think about it: A stock like Dollar Thrifty Group that can jump 4,000% in a single year has a much greater potential to make option buyers rich than more stable stocks like Johnson & Johnson. So investors will pay more for options on volatile stocks -- and if you're willing to take on that risk by selling them, you'll make proportionally more when things go your way.

Don't get burned
Of course, that volatility works both ways: You'll get a bigger premium up front, but if the trade goes against you, options on more volatile stocks can create bigger losses for you as well. Even if you use a conservative strategy like selling covered calls, you may miss out on a big potential gain if your shares get called away.

Still, options are definitely worth a closer look, especially if you don't fully understand them. If you want to know even more about how options tick, you'll want to learn from the best. And your timing couldn't be better, because right now, our Motley Fool Pro team is opening its doors with a limited-time offer. To find out all about it, just put your e-mail address in the box below.

Fool contributor Dan Caplinger likes to keep all his options open. He doesn't own shares of the companies mentioned in this article. American Express and Coca-Cola are Motley Fool Inside Value recommendations. Johnson & Johnson and Coca-Cola are Motley Fool Income Investor selections. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is stricter than a ruler-wielding teacher.


Read/Post Comments (0) | 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.

Be the first one to comment on this article.

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: 1093619, ~/Articles/ArticleHandler.aspx, 8/30/2014 12:37:00 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