Investors face a huge amount of uncertainty right now. Stocks are up modestly for the year, but they're well off their highs. Bonds have posted some significant gains, but their yields are at rock-bottom levels, and you have to take on some credit risk to get decent yields on most bonds. Even dividend stocks, which many used to consider boring and unremarkable, have seen their prices rise so far that some worry they're looking bubbly. Yet on the whole, investors don't seem particularly fearful about the prospects for an imminent decline.
When you add all those factors up, it's time to take a closer look at a strategy most people never think of: Buying options.
Buy low, sell high
Many investors dismiss options because of their reputation as being purely speculative. Sure enough, you'll find no shortage of get-rich-quick schemes involving options, trying to lure you in with the prospect of quick 1,000% returns.
But smart investors understand that options are only as risky as the particular strategies you use with them. Just as some stocks will take you for the ride of your life while others are relatively stable, so too can you choose a variety of different risk levels depending on how you use options.
In particular, now's a good time to consider buying options. Conservative investors tend to sell options, reaping small premiums rather than paying them. But options are relatively cheap right now, and so it makes more sense to be a buyer of options than a seller. Moreover, options can give you more favorable risk-reward prospects than buying shares outright.
What's in an option?
To understand why options prices are attractive right now, you need to understand how option prices work. An option's price depends on several things: the price of the underlying stock, the strike price at which the option calls for you to buy or sell shares, the amount of time left until the option expires, and the volatility of the underlying stock. With current volatility levels low, options prices are lower than they would be under more normal circumstances.
Those cheap prices make it possible for you to capture most of the same upside potential of owning shares while limiting your downside. For instance, Baidu (Nasdaq: BIDU ) has lost a third of its value in less than a year as China's economy has slowed down. If you think it will bounce back, you could buy shares at around $109. But you could also pay about $18 per share for options to buy Baidu stock for $100 any time between now and January. Similarly, PotashCorp (NYSE: POT ) has had a wild ride as strong farm demand battles with high potash mining costs. You can buy shares for around $44.50, or a call option for $6.75 per share to pick up the stock any time before mid-January for $40.
In both cases, the tradeoffs are clear. If you end up exercising the option, you'll pay more in total for your shares -- $9 more in Baidu's case, and $2.25 for PotashCorp. But you'll have two advantages to counterbalance that extra cost. You won't put as much money at risk, as the most you stand to lose is whatever you pay for the call option. And if the stock price drops sharply, you don't have to buy the shares. Rather, you can just let them expire unexercised, saving you from an even bigger loss.
Oddly enough, in some situations, you can profit from options even if the price action moves against you. Rising fear about the stock market can push implied volatility up, bringing options prices up with it even if the shares don't budge. Compared to exchange-traded volatility plays iPath S&P 500 VIX Short-Term (NYSE: VXX ) or VelocityShares Daily 2x VIX Short-Term (NYSE: TVIX ) , using options directly to bet on volatility is less prone to tracking error or other potential mishaps.
Options aren't for everyone. But if you're looking to reduce your overall risk level while still retaining some upside, today's relatively cheap option price environment is tailor-made for strategies using options.