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If you're like many investors, you've probably never given investing in options a second thought. After all, a simple portfolio of mutual funds, ETFs, and individual stocks can give you a simple and perfectly acceptable way to achieve the main goals of your financial plan.
But despite the bad reputation that options have gotten over the years, they can actually be quite helpful. Used correctly, options let you dial in the exact risk level you want in your overall portfolio without making massive changes to your core investments every time market conditions change.
Below, I'll introduce some of the options strategies that smart investors use to hedge their risk and create unique profit opportunities. But first, you need to understand the background of why so many people think options are a sucker's bet.
The dark side of options
Right now, options have two things going against them. First, options are a type of derivative, in that their value comes entirely from their relation to whatever underlying security the option covers. The dangers of derivatives like options and futures have once again appeared in the spotlight, as the MF Global scandal left many of its customers unable to close positions and may result in their having lost individual-account money that should have been segregated away from MF Global's own corporate funds. Similar counterparty issues exist for options covering stocks, and although clearinghouses are supposed to make options trading safe, the MF Global failure calls those assurances into question.
But the longer-standing problem with options' bad reputation is that they're one of the primary ways that executives boost their compensation -- especially after massive market collapses that leave most shareholders with big losses. For instance, in 2009, several company executives, including Starbucks (Nasdaq: SBUX ) CEO Howard Schultz, Sirius XM's (Nasdaq: SIRI ) Mel Karmazin, and Alan Mulally of Ford (NYSE: F ) , received big options grants -- grants that jumped in value as the market bounced off the early 2009 lows in one of the biggest market recoveries of all time.
At the same time, though, companies over the years have tried to have their cake and eat it too by making modifications to the options they gave their employees. Brocade Communications (Nasdaq: BRCD ) saw its former CEO get a prison sentence for backdating its stock options in order to boost their value. Similarly, large companies like Apple (Nasdaq: AAPL ) , Dell (Nasdaq: DELL ) , and UnitedHealth Group (NYSE: UNH ) have had to deal with controversy surrounding their own options-grant practices.
Fortunately, you can still use options to your advantage.
What options can do for you
Like any other tool, options are only as good or bad as the uses they're put to. Although speculators routinely use them, you might prefer some of the following alternative strategies:
- Covered calls can help you turn stocks that don't pay dividends into big income-generating investments -- or get even more income from your dividend-paying stocks.
- Writing put options gives you the opportunity to get paid while you wait for a stock to trade down to a more attractive entry point.
- Buying calls lets you have positions on stocks without putting as much money at risk.
- Buying puts protects you from big, unexpected drops in your stocks.
Throughout this week, I'll take a closer look at each of these four techniques, along with some sample stocks that they're well-suited for.
In general, though, the key to understanding options is that when you forget all the hype, options aren't inherently risky. Sure, some options investors lose everything quickly because they swing for the fences. But if you focus less on the leverage options offer and more on their risk-control abilities, you'll do much better in the long run.
To make the most of options, though, you have to understand them inside and out. That's why the Motley Fool put together an "Options University" to give you the knowledge you need to be smarter about options. Just enter your email address in the box below to get this free report -- but don't wait, because that box won't be there forever.