For a long time, I've felt like the cat who caught the canary. Despite being a Fool since 1994, I've been using stock options this past decade, and realized years ago what a strategic, useful, and profitable tool they can be -- even for a long-term stock investor.
While options earn returns in the near term, measured in months or a few years, your stocks can be left alone to generate returns over many years, so you have the best of both investing worlds: near-term and long-term gains.
But that's not all. With sensible options strategies, you can earn extra returns on your favorite stocks whether they go down or stay in a range for months. You can also set up strategies to buy more shares of your favorite companies at lower prices, and get paid a profit if your buy price doesn't come along.
On the flip side, when you're ready to sell a stock, options can net you a higher sell price on your shares, or pay a profit even if your desired sell price hasn't materialized yet. These are just two simple examples: There's actually an options strategy for just about any situation imaginable.
Stocks, meanwhile, are a binary investment: They only go up or down. And they're meant to be long-term investments. Options are a more flexible tool, offering profits in a wide variety of situations, usually measured in months. Still have doubts? Let's run through a few examples.
Buying a stock cheaper
Cisco (Nasdaq: CSCO ) was recently trading around $24 per share. Assume you would like to buy shares of the tech giant, or add to your existing shares, but with the stock trading at a rather moderate 19 times earnings, you want a slightly lower price to give you a better margin of safety.
Rather than sit and hope that a better deal comes along, you could write ("sell to open") put options expiring in October 2010 with a $22 strike price. These options will pay you about $1.40 per share today, and that money is yours to keep. If you write one contract, you'll be paid $140 before commissions because each option contract represents 100 shares of the stock.
So, you write the option, get paid the premium, and then wait. If Cisco is below $22 by your option's October expiration date, you'll be "put" the shares into your account -- in other words, you get to buy the shares and own them for the long haul. You still keep the $1.40 per share you were paid to write the options, so your actual buy price on the stock is just $20.60, or 14% below today's price. Well done!
Now, if Cisco is above $22 by expiration, you just keep the $1.40 per share (which equates to a 6% return on your potential $22 buy price in under six months), the option expires, and you can consider your next move -- perhaps writing more put options for more income and another shot at buying Cisco cheaper. As long as you believe in Cisco and the valuation you're targeting, you can do this strategy repeatedly. But if you think Cisco is going to keep trending higher, you may want to own some shares, too.
There's nothing unusually risky about this put-writing strategy as long as you have the means to buy the stock if it declines. Mathematically, put-writing is less risky than buying a stock outright at today's higher price. The strategy is simply a way to buy a company you like if it declines to your desired price or lower by your option's expiration, or to be paid income if not.
Intel's (Nasdaq: INTC ) scale gives it an enormous advantage over Advanced Micro Devices (NYSE: AMD ) : Despite outspending AMD by a nearly 4-to-1 margin, research and development costs make up just 15% of its revenue compared with AMD's 28%. That stability that competitive advantage provides means writing puts is a sensible strategy for Intel (though not as much for AMD). It's one that could pay you regularly, or (if Intel declines enough) end up netting you shares at a lower, better buy price.
The two main risks: Intel soars, and you don't own any shares yet (which is why we often suggest owning at least a partial position, along with writing puts); or, it tanks far below your net buy price.
In other words, selling puts might not be a great strategy for purchasing binary outcome stocks. Despite the high prices their puts fetch, start-up biotechs like Cell Therapeutics (Nasdaq: CTIC ) , which depends on FDA approval for its three cancer treatments, and solar stocks such as Suntech Power (NYSE: STP ) and LDK (NYSE: LDK ) , which need solar energy to become cost-competitive with traditional sources, wouldn't be great candidates for this strategy. (There is, however, another strategy to profit from binary outcome stocks whichever way they go.)
Ready to sell a stock
For this example, let's say you're ready to sell a stock if the right price comes along. Assume you own at least 100 shares of Starbucks (Nasdaq: SBUX ) , recently trading around $27 -- near the high of its 52-week range. If shares were to reach $30 soon, you'd think they were overpriced and not about to soar based on the introduction of some revolutionary new product, so you'd happily take your profit and go. Today, you could write $30 strike price call options on Starbucks that expire in October 2010 and be paid $1.00 per share. That money is paid to you now and yours to keep.
Assume the stock ends the October expiration date anywhere below $30. You keep that $1.00 per share (which equates to a 4% yield on the stock's current price, earned in under six months), and you keep your shares, too. As the options expire, you can consider your next move, perhaps writing new covered calls for another payment.
However, if Starbucks is at or above $30 by the expiration date your shares are "called" away from your account, sold at $30. You still keep the $1.00 per share, so your effective sell price is $31, a price you believe overvalues the stock. You've actually earned additional profits while selling a stock you wanted to sell anyway. The main downside to covered calls: If Starbucks soars to any price above $30 by October, you would still be on the hook to sell your shares at a net $31. But if Starbucks goes down, at least your covered calls earn you a profit while you wait for it to recover.
Options are strategic tools, not speculation
If you use the handle of a screwdriver to try to turn a screw, you won't be happy with the results. Like any tool, your outcome with options depends on how you use them. Options are great tools when used strategically, utilizing what you already know about a good business and its valuation.
Warren Buffett has written put options (just like our first example on Cisco) to buy shares of Coca-Cola cheaper long ago, and recently he was writing puts on Burlington Northern to buy more shares before he announced he'd acquire the whole company.
To learn much more about options and our favorite strategies -- ones I've used publicly in real-money portfolios for years -- or to find out more about Motley Fool Options, just enter your email in the box below. If you do, you'll get a free report with five strategies for growing your wealth in a volatile, range-bound market with options and exchange-traded funds -- plus a bonus idea for trading when volatility is high.