- Options are financial tools that provide investors increased leverage and improved payoffs in return for an assumption of high risk over a short period of time.
- As tools, options have valid uses, both in business and in investing.
- Because options generally are short-term in nature and generally cost more in commissions, taxes, and time, they are not, in my opinion, very compatible with the classic Rule Maker investment approach.
Here's our third and final scenario from fserrano:
"I could be an ANALYTICAL investor and still use options as a strategy to accomplish my goals. Example: An investor has done a lot of research on Dell Computer (Nasdaq: DELL), and he believes in its business model and would love to own a piece of it. However, he thinks that $41 per share is a little much. Therefore he would prefer to buy it at $36. He is aware that timing the market is a fool's game, but maybe he only has $3600 in his Ameritrade account and after watching Dell's historical price chart, he thinks it is very probable that Dell will come down a bit. He could place a limit orderï¿½OR he could write a put (a DEC 40 at 4). With this contract he receives $400 and for the next two months he could be obligated to buy 100 shares at $40 per share. If Dell never comes down, he will keep the $400 but doesn't get to buy the stock. If Dell does come down, he buys 100 shares at 4000 (he ends up paying $36 a share: 40-4) With the limit order he wouldn't get the stock if Dell went up and would pay 40 instead of 36 if Dell went down."
In this example, an investor wants to buy Dell, but doesn't want it at the current $41 price tag. So he sells (or "writes") a put option for $400, which he can invest in the meantime. If Dell doesn't drop within the two months, he gets to keep the money and split his profit with the government. If it does drop under $40, the put gets exercised (the stock gets put to him) and our investor buys it at an effective price of $36. Of course, if the price of Dell goes lower than $36, the investor still has to buy it at the after-premium $36 per share. In this case, however, the outcome is the same as if a limit purchase order was used to buy the stock at $36.
To accomplish the same goal of acquiring Dell at $36, a RULE MAKIN' FOOL would have to either use a buy limit order at $36. Or, if confident in his analysis that Dell's price will drop, he could just wait to see if he can pick up some shares below that price. Of course, if Dell doesn't drop to $36, then our Rule Maker doesn't get any stock, nor is he compensated by the option premium.
Of fserrano's three scenarios, this is the example that I would consider to be the best (and most conservative) use of options in a way that offers unique value to an investor.
It is obvious that there are many smart investors on our message boards, and many have used or continue to use options to pursue their various strategies. There is nothing inherently un-Foolish about this. I certainly don't universally condemn the use of option strategies. Each of the scenarios that fserrano supplied is a valid use of options, in the sense that the investor knows exactly what he wants to accomplish, is aware of the risks involved, is willing to pay the price, and is presumably prepared for the downside. Options are tools, and as such, offer utility to investors.
I would like to acknowledge that I am not an expert on options (or anything else, for that matter). If you feel that options have something to offer you, I encourage you to do some more research on the subject and determine for yourself whether they might fit in your investment philosophy. The first rule of Fooldom is to do your own research and take responsibility for your own choices. Fserrano recommends the following books to get you started:
- Getting Started in Options by Michael Thomsett
- LEAPS by Harrison Roth
- Options: A Personal Seminar by Scott Fullman
I'd like to thank fserrano again for his excellent post on the subject, and also all the other Fools who contributed to the discussion on the message board.
Until next time, keep on Foolin'