Many investors think of options as the stock market's equivalent of playing the lottery. But you don't have to use options that way. Even the simplest of options strategies can help you capture the rewards of owning stocks while actually reducing your risk.
The beauty of the call option
Yesterday, I introduced options and explained how they've managed to get a bad reputation among long-term investors. With speculators and short-term traders often turning to options as a tool to maximize their leverage with limited capital, those with longer time horizons may see options as unnecessarily risky. But before you dismiss options out of hand, let's take a closer look at what a call option is, and how you can use it to your advantage.
Call options give you the right to buy stock at a particular price within a given timeframe. Typically, each options contract you buy represents 100 shares of stock. As the option gets closer to expiring, you'll have a decision to make based on the stock's price. If the current price is more than the amount you have to pay under the option's terms, which is known as the strike price, you'll exercise the option and pick up shares at a discount to their current market value. On the other hand, if the current share price is less than the strike price, you can simply let the option expire.
That second outcome trips up many investors. If the option expires, you'll suffer a 100% loss on whatever you paid up front for it. That potential for a complete loss makes many believe that options are inherently riskier than stocks.
But just because you can use options to multiply your leverage doesn't mean that you have to. If you match the number of options contracts you buy to the number of shares you'd otherwise purchase, you're not making a leveraged bet. And at times like these, when the stock market has already put in some huge gains, using a simple call option strategy can put less of your money at risk than if you simply bought stocks outright.
As examples, these seven S&P 500 stocks are among the index's top 25 gainers since the market's 2009 lows, all having gone up at least 500% in the past two years. For each, I looked up how much it would cost to buy a typical call option as of yesterday's close:
2-Year Total Return
|JDS Uniphase (Nasdaq: JDSU )
|Wynn Resorts (Nasdaq: WYNN )
|Ford (NYSE: F )
|Tenet Healthcare (NYSE: THC )
|Cliffs Natural Resources (NYSE: CLF )
|Limited Brands (NYSE: LTD )
|SanDisk (Nasdaq: SNDK )
Source: Yahoo! Finance. Prices as of March 7.
So to take an example, a call option giving you the right to buy 100 shares of Ford stock for $14 per share at any time between now and mid-April would cost you $69. If the share price rose to $17 by next month, you would exercise the option and pay $1,400 for 100 shares worth $1,700, earning a profit of $300 less the $69 you paid for the option. On the other hand, if Ford shares fell to $10, you would let the option expire without exercising it. You'd lose the $69, but you'd avoid the $400 loss you'd have suffered if you'd bought the shares at their current price around $14.
Using call options can be especially useful when prices have risen so strongly, because such stocks are typically susceptible to the risk of a major pullback. Yet even when the fundamentals of a stock don't support a further rally, momentum can carry stocks still higher even after a big run. Call options give you the upside from continuing momentum while limiting your maximum potential loss. As you can see, though, that protection comes at a price; even short-term options like these can cost as much as nearly 10% of the current share price.
Buying call options is one way to use options strategies as an alternative to buying stocks, but it's definitely not the only strategy. Tomorrow, we'll take a look at how selling call options can sometimes be even more lucrative, helping you increase income from your investments.
To learn even more about options, be sure to check out our Options Center. You'll find a tutorial on options and much more.