No, I'm Not Playing With Fire

My Foolish colleague Paul Elliott once wrote an article likening investors using options to dumb kids riding motorcycles, arguing that either can leave you dead. That's why he says he avoids both of them

Now, as he points out, motorcycles are neither inherently good nor bad -- they're just a means of transportation that can be used well or foolishly. Similarly, options are neither good nor bad, but rather, are simply tools. As with any tool, proper education in handling and use is key.

And much like Paul, and his teenaged realization that, while motorcycles were cool, he'd probably personally get himself killed, the lesson for the options user is not "Abandon All Hope, Ye Who Enter Here."

Instead, it's "Investor, Know Thyself."

You see, Paul has used options
Or rather, Paul has invested in ways that mimic how options behave. Let me explain.

Consider a simple call option, which gives its holder the right to buy the underlying stock at a pre-specified price (the strike price) any time up to expiration, which might range from as little as a day to well over two years. At expiration, the decision is pretty simple -– if the stock price is greater than the strike price, you buy the stock. If the stock price lags the strike, you don't.

At its root, a call option has a binary outcome: Profits or nothing.

Paul's self-admitted weapon of choice in the 1990s was small biotech companies. Such companies are generally cash-burning engines, hoping that the wonder drug they've got in their pipelines will prove more effective than a sugar pill and get bought up by the likes of Pfizer (NYSE: PFE  ) . The pharmaceutical giant lost patent exclusivity over its blockbuster cholesterol drug Liptor, and saw an 11% sales decline in Q3, as generics started encroaching on non-U.S. sales. If purchased drugs/technology are a hit, the company that created them will probably become a multibagger. If it isn't, it'll likely bleed out via cash burn, leaving their investors with nothing.

A binary outcome: big profits, or bupkis. Doesn't that sound like a call option?

What's love got to do with it?
Paul goes on to say that while he eschewed Cisco (Nasdaq: CSCO  ) and Oracle (Nasdaq: ORCL  ) and other stocks that "everybody loved" (I imagine valuation was a concern there), he admits to "falling in love" with his own stocks. And the consequences of that, dear Fools, is exactly what options can help you prevent.

Why? Options depend on a clear valuation of the underlying stock. Once you've got a firm valuation, you can overlay an appropriate options strategy.

Take Chipotle (NYSE: CMG  ) as an example of a stock that many people seem to have fallen for. And it's not hard to see why: The most recent quarter saw earnings up 41%, revenue up 23%, copious cash generation, profit margin expansion, and co-CEO Steve Ells dressing up as dipping sauce (alongside Jamie Oliver as a chicken nugget). And this blow-out quarter was only the latest in a string of such robust results. While I admire the company immensely (indeed, I own some shares, purchased at a significantly lower price), the stock today is too pricey for me on a valuation basis.

But options -- employed Foolishly -- give us more choices regarding fair Chipotle. You could sell a put option at a strike price lower than today's trading price, which nets you cash up front and guarantees a lower future purchase price if Chipotle's price falls.

Or, if you already own Chipotle, and believe that there's some hefty growth assumptions built into the present price, you could sell a call option at a higher strike price, guaranteeing that you'd sell at a still higher price (one that your valuation work tells you is assuredly overvalued) while gaining some income.

And there are any number of other strategies you could put into play to mirror your beliefs about Chipotle's prospects vis-a-vis the present valuation -- bullish, bearish, or neutral.

At bottom, options are simply an extension of the buy-and-hold belief in valuation -- they just offer more ways to profit on a given company.

Knocking down the straw man
Can investors wipe themselves out with options trades, the way Paul's friend did?

Well, sure. Remember, Paul never bought a motorcycle because he knew he'd do something stupid. His friend, on the other hand, actually did something stupid -- using options as if they were betting chips, and getting suitably slapped for his speculation. If you're blindsided by a massive five-figure loss, I'd bet you went into the transaction not having worked through the potential outcomes.

But that's true of buying stocks long, too. Just take a look at the 10-year stock price charts for Alcatel-Lucent, JDS Uniphase (Nasdaq: JSDU  ) , or, if you can find it, the now-bankrupt Nortel Networks (once worth over $360 billion Canadian at the height of the tech boom). Not to feel left out, the past couple of years of performance by financials or insurers who didn't understand the risks they took on (think Citigroup or AIG (NYSE: AIG  ) ).

Ironically, when stocks are overvalued, an options strategy -- buying puts -- can enable investors to protect their money while watching to see whether the market euphoria continues to rack up gains.

Getting wiped out via option use is an oft-trotted-out fear, but you can wipe yourself out perfectly effectively by buying stocks on anything other than ongoing valuation.

(What's so funny 'bout) peace, love, and understanding?
All of this is not to dog on Paul (much). I actually share his opinion that the vast majority of individual investors can happily go through their investing lives without ever buying or selling an option. And sure, acting stupidly is bound to end badly -- no matter what arena we're talking about.

But investors who are committed to valuation and interested in taking a more active role, enhancing their returns, generating some additional income, or protecting their hard-won gains should seriously consider options, which can do all of that and more, and without necessarily adding any additional risk.

If you want to find out how -- and how we're using options Foolishly, based on business fundamentals and valuation -- just enter your email in the box below to check out Motley Fool Options and receive a free options guide.

Pfizer is a Motley Fool Inside Value selection. Chipotle Mexican Grill is a Motley Fool Rule Breakers recommendation. Chipotle Mexican Grill is a Motley Fool Hidden Gems pick. The Fool has written a bull call spread on Cisco Systems. The Fool owns shares of Chipotle Mexican Grill and Oracle.

Jim Gillies, co-advisor of Motley Fool Options, owns shares of Chipotle. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On December 01, 2010, at 8:24 AM, TMFmd19 wrote:

    I highly recommend MF Options to anyone who wants to learn about how options work and how to use them as a tool in your portfolio. Jim and Jeff are both fantastic teachers and great stock pickers. My MFO experience has been more valuable to me than that MBA I got and a lot cheaper too!

    Matt

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