Are Options a Sucker's Bet?

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:

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.

Learn more
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.

Fool contributor Dan Caplinger likes keeping his options open. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of Apple, Ford, UnitedHealth, and Starbucks. Motley Fool newsletter services have recommended buying shares of Starbucks, Apple, Ford, Dell, and UnitedHealth, as well as creating a bull call spread position in Apple and a diagonal call position in UnitedHealth. Try any of our Foolish newsletter services free for 30 days. 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 Fool's disclosure policy gives you all the options.


Read/Post Comments (11) | Recommend This Article (8)

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.

  • Report this Comment On December 05, 2011, at 11:08 AM, bartok1925 wrote:

    Please label articles such as this as the plug that they are, so I don't waste time reading them.

  • Report this Comment On December 05, 2011, at 11:09 AM, Palido wrote:

    Options trading and options grants are not the same thing. Why present them as such?

  • Report this Comment On December 05, 2011, at 11:26 AM, Brettze wrote:

    Why must options be traded in 100 share lots only? Why not have 10 share options or 50 shares options?? I need to diversify .

  • Report this Comment On December 05, 2011, at 11:30 AM, Brettze wrote:

    Option traders influence the mood of the stock market . Common stock prices are affected by option trades.. Options has decaying time which mean that traders look at the options and delay buying or selling until the decaying destroy most if not all of the options before resuming.. Where is the privacy of option traders? Same thing happens when you set stop loss orders on your common stocks.. Traders can see your order on the screen and act opposite you.. The best way to trade is to act instantly without warning... especially at right times.. It is not always easy..

  • Report this Comment On December 05, 2011, at 11:32 AM, Brettze wrote:

    You can also make fake limit orders which mean that you can cancel later on.. This will spook the traders on the floor for nothing.. This will muddy up their minds.. You can either follow through with some of your fake orders and exceute them anyway butnot always.. this will keep them guessing..

  • Report this Comment On December 05, 2011, at 11:32 AM, Brettze wrote:

    it is like making sucker punchs... c'mon pfft !

  • Report this Comment On December 05, 2011, at 2:24 PM, TMFGalagan wrote:

    @palido -

    I didn't equate option grants to options trading. But many people erroneously think they're the same thing and therefore avoid trading options.

    best,

    dan (TMF Galagan)

  • Report this Comment On December 05, 2011, at 6:10 PM, Millsteen wrote:

    In the past few months I've been writing puts on quality stocks that I wouldn't mind owning at the right price. My % return on these short term bets can be very significant in the 15 to 30% range. During the market downturn in Sept. I ended up owning a few of these stocks when they were "put" to me. The market then rallied and I sold covered calls against these newly owned stocks for additional premiums. I consider the above "betting" strategies one of the less risky option strategies but my advice is to start slowly and get the hang of it.

  • Report this Comment On December 06, 2011, at 1:50 AM, PostScience wrote:

    I have to say this article feels like an ad.

  • Report this Comment On December 06, 2011, at 12:14 PM, SisyphusLearned wrote:

    There are some astonishing inaccuracies in this article, which point to either a surprisingly level of laziness in the author's research, or perhaps outright lying.

    MF Global went under because of bets on European sovereign debt - not derivatives of any kind. The further scandal with their client's segregated funds is not a counter party issue because it doesn't involve a specific trade - which is why the exchanges didn't step in. Last but not least, futures and options on futures are regulated by the CFTC, while stocks and options on stock are not. So the suggestion that both share "counterparty risks" just because they are both derivatives shows, again, either outright deception or severe intellectual laziness.

    Once you get past the plethora of falsehood in the intro, the body of the article outlines the most basic and oversimplified view of options possible, and I particularly love the part where the author says "options aren't inherently risky". All investments are risky, otherwise there wouldn't be two sides to a trade.

    What audience is this piece intended for? Mr. Caplinger is doing the "suckers" a disservice with this article, and everyone else show know better than to believe anything the author says in the future, after reading this.

  • Report this Comment On December 07, 2011, at 6:07 PM, daveandrae wrote:

    Is the options market just another form of legalized GAMBLING?

    Of course it is.

    Nuff said.

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