Since there is obviously an interest in the pros and cons of options usage, I'd like to use today's column to explain a bit about how options work, and also to throw out some reasons why I think options don't offer much to Rule Maker investors. Then, on Monday, I'll address the specific examples introduced by fserrano in his post. Before going any further, I encourage you to read fserrano's post by clicking on this link.
For those of you who aren't familiar with options, let's do a quick tour of the terrain. An option represents the right (but not the obligation) to purchase or sell a given instrument (in this case, a stock) for a specific price on or before a specific date. The right to purchase stock is referred to as a call option. The right to sell stock is referred to as a put option. The purchaser of an option pays for this privilege via an upfront fee called a premium. This premium compensates the seller (sometimes referred to as the writer) of the option for the risk that the seller is assuming by doing the transaction.
Watch out, because those textbook definitions have been known to cause a nasty case of eyes-glaze-over-itis. Let's walk through an example of buying a call option that should help this stuff sink in.
Let's say that instead of purchasing shares of Pokemon Inc. (Ticker: FAD), currently selling for $75, an investor could purchase the option to buy 100 shares (one contract) at $80 in three months time. This option might cost $3 per share. So, for a total outlay of $300, (plus commission), our investor can benefit from any rise in Pokemon stock over the next three months above $80. In three months time, if Pokemon has risen to $90, our investor can exercise the call option and purchase 100 shares at $80 each, or $8000. Since these shares are now worth $9000, the investor has made $1000, minus the option premium of $300, for a total profit of $700. Since the initial investment was only $300, our investor has made an incredible 233% profit in three months. Pretty impressive, huh? These options sound like easy money, right?
Well, not so fast. If Pokemon doesn't rise to at least $80 in the next three months, then the entire $300 is gone. Poof! An equally impressive 100% loss of the investment occurs. That's the nature of options, and the seeming ease of generating high percentage profits is in reality largely offset by the price of the premium and the risk of losing the entire investment. Of course, this must be true, or there would be nobody willing to sell the options, since the people who sell options aren't dumb enough to keep playing a losing game.
You may be wondering how the seller decides how much to charge for the option. Normally, the seller uses some variation of the Black-Scholes formula, which was developed by Fisher Black and Myron Scholes (later of Long Term Capital Management infamy) in the early 1970s. The formula has six basic variables, which are the current stock price, the stock price at which the option is set (called the strike price), the amount of time to expiration, the volatility of the stock (note: this is not the same thing as beta), the current risk-free interest rate, and whether the stock pays cash dividends.
Since most stock options are traded on an exchange, the price is set by the exchange using one of the variations of this formula. Like insurance policies, options are priced in such a way that the sellers of the options will win the vast majority of time. This must be so to compensate them for the risk of the occasional big loss due to the exposure to theoretically unlimited downside risk.
Let's discuss the risk profile of an option. The purchaser of an option has an entirely different risk profile than that of the seller. The purchaser has a limited downside risk (i.e., he can risk his entire investment amount, but no more), and unlimited upside profit potential, seeing that there is no limitation as to how high the price of a stock can go. The seller of an option receives the premium, but won't get anymore money after that. Therefore, the seller has limited profit potential in the form of the premium, but could suffer unlimited losses if the price of the stock goes to infinity.
Now that we have a basic understanding of how options work, here are some reasons why they hold no particular interest for us Rule Maker investors.
First of all, when you buy options on stocks, you are not buying a piece of a business, but rather you are buying (or selling) the volatility in the price of the underlying stock for a specified (usually short) period of time. When you buy an option, you pay a price for the right to the upside price change (in the case of calls) or to limit the downside price change (in the case of puts) for a limited time.
In the Rule Maker portfolio, we buy stocks with an intended investment horizon of at least five years, and preferably ten years or more. As long-term investors, we don't place a lot of confidence in our abilities to predict price movements of a given stock over the next one to three months. We prefer to put our confidence in the wealth creation capabilities of outstanding businesses over a period of three to ten years. Given enough time, we are confident that the value created by Rule Maker companies will eventually be reflected proportionately in the price of the stock. Therefore, it follows that using our investment capital to speculate (yes, that's the word for putting money in options) on price movements doesn't hold a lot of fascination for us.
Secondly, keeping transaction and tax costs down to a minimum is central to the Rule Maker philosophy. By limiting our commission costs to under one percent of our assets per year, and by deferring taxable gains as long as possible, Rule Maker investors have a much better chance of beating the market than an investor who makes a lot of transactions. Because of their limited life span, options require multiple transactions. Repeat transactions result in repeat commissions, which in the case of options, can be outrageously expensive, even at a discount broker.
Since I can't trade options on my Datek account, I asked Matt to check out the commissions for options on Suretrade, where the Rule Maker account currently resides (though we're in the process of switching to AmEx's new brokerage). Suretrade's commission for stocks is only $7.95 a trade. Purchasing an option, however, costs $21, plus $1.70 per contract, with a minimum transaction of $28.95. And that's just to buy the option. When you want to exercise the option, it costs you another $34.95! At these rates, if you use options consistently, you could easily pump up your transaction costs to four or five percent of your assets on an annual basis. For small investors, this is a very high price of admission just to play the game.
Third, there is the risk factor. As Rule Maker investors, we prefer the high percentage plays of investing in proven winners. Additionally, we limit the risk in our chosen stocks by dollar cost averaging into them over time. Options, on the other hand, are an all-or-nothing game. If you're right, you can easily generate 100% on your investment. But you have to be big time right to overcome the weight of the premium and the commissions. If you're just a little bit right, you can still be wrong in the options game.
Say the stock that you knew was going to go up suddenly jumps 50% five months from now, and you only had a three month option. You're out of luck. And if you're wrong, you lose 100% of your investment. The reason that options allow you to generate such high percentage profits when you bet correctly is because of the leverage involved. In the case of a call option, you can purchase the short-term upside in a company for the next three months for a small fraction of what it would cost you to actually own the shares outright. If the stock makes a 10% move up in that time, you have doubled your money. This get-rich-quick feature of options is the light that lures inexperienced investors like moths, and also makes it all too easy for charlatans to take advantage of the naive. Unfortunately, most of them don't realize the downside until it's too late.
On Monday, I'll be back to review some specific examples of what fserrana submits as the intelligent use of options, and I'll respond as to how this Rule Makin' Fool would likely view those situations. Until then, head on over to our message boards and weigh in with your opinions!
Have a great weekend! And while you're at it, tomorrow's Fool Radio Show will feature Harry Beckwith, author of the Jester-Award-Winning Selling the Invisible, and Craig Venter, President and Chief Scientific Officer of Celera. Celera is one of the companies working on cracking the genetic code and Mr. Venter is considered one of the foremost authorities in this field. If Fool Radio isn't available in your town, you can always listen online.
One final note: Over in today's Fool on the Hill, Bill Mann is ranting about why you shouldn't own Rule Maker Cisco. Check it out and let us know what you think on the Cisco board.