Most investors are somewhat familiar with equity options. Equity options are simply rights to buy or sell the underlying stock at a certain price within a specified period of time. Options can be quite risky and are best left to experienced or well-capitalized investors. However, when properly understood and prudently used, options can offer excellent returns with excellent risk/reward profiles.
I'll briefly illustrate the basic workings of a stock option with a real example. Consider Home Depot (NYSE: HD ) . Home Depot currently trades around $26 a share. The January 2008 call (right to buy) options with a strike price of $30 are changing hands for about 15 cents a share. Since options are traded in 100-share lots, each option will cost you $15 (forget commissions for this article, although such frictional costs should always be considered in real life). It is this ability to leverage your capital that gives options their appeal. Buying 100 actual shares of Home Depot will cost you more than $2,600 versus the $15 option. However, it is this ability to leverage that also makes options a perfect way to suffer permanent loss of capital.
The simple (and dangerous) math
Instead of purchasing 1,000 shares of Home Depot for around $26,000, an investor decides to purchase the January $30 calls at $15 each, getting about 1,733 contracts representing 173,300 shares. At expiration, Home Depot shares are trading for $32. A stock investor is sitting on a profit of $6,000, or a 23% gain. The option contracts are worth $200 each because they each convey the right to buy 100 shares of a $32 stock for $30. Thus the 1,733 contracts are worth $346,600, or a sizzling 1,233% gain!
It is these types of numbers that attract exactly those individuals who should stay away from options. First, my example is highly exaggerated. It assumes that Home Depot shares could rise 23% in one month. Sure, this is possible, but the likelihood is very low. This is because Home Depot has very little price volatility. The more volatile a stock's price is, the more expensive its underlying stock options will be.
Consider First Marblehead (NYSE: FMD ) , a private outsourcer of educational loans. The company has been an extremely volatile stock over the past months. At one point this month, First Marblehead was down more than 50%. That was before Goldman Sachs (NYSE: GS ) announced its capital infusion today. The shares are up more than 60% today, further adding to the increased price volatility which serves to make the option prices more expensive.
The prudent way: LEAPS
Now that you can see the severe capital impairment that options usually cause for most investors, there is one option that offers investors the opportunity to exploit options' advantages while attempting to minimize their disadvantages. Options exist for a finite period of time. It is this timing that tends to wreak havoc on the option owner. The shorter the lifespan, the "cheaper" the options, but that means less time for the underlying stock to do its thing. Conversely, a longer lifespan gives more time for the stock to perform, but it will cost you more.
LEAPS stand for Long-Term Equity Anticipation Securities. Basically, they are long-term equity option contracts. LEAPS are typically two to two-and-a-half years in duration. So, rather than having a month for a stock to play out, you are given considerably more time.
When used prudently and intelligently, LEAPS can offer an opportunity to invest in a business with a lower initial cost of capital. I cannot emphasize the importance of participating in LEAPS only after you understand the advantages and disadvantages. Every day that goes by means the value of your option is declining at an accelerating rate. The two-year window that LEAPS offer, however, provides investors with opportunities to take advantage of stocks in out-of-favor industries that are due for a recovery. For instance, I believe homebuilders like Toll (NYSE: TOL ) and NVR (NYSE: NVR ) , along with the likes of Home Depot and Lowe's (NYSE: LOW ) , are due for a rebound. LEAPS offer one way to participate in that potential turnaround.
In most situations, options investing should be avoided. It's a game of leverage where the odds are usually stacked high against you. I also believe that certain characteristics must exist in a business before the possibility of investing in it via long-term options should be considered. These specific characteristics should be understood fully before committing capital. In part 2 of this piece, these characteristics will be discussed in greater detail.
As Foolanthropy enters its second decade, join us in working to bring financial education to the world's children. Learn more about Foolanthropy's new direction.