This article was originally published as part of a Dueling Fools series. It has been updated.
"Options don't lose people money. People lose people money."
OK, this takeoff on the famous gun-lobby quotation may be a complete plagiarism, but it gets my point across. Options are an incredibly flexible tool that investors can use for good, or for ill. Used properly, options can reduce risk, not increase it. Granted, gun-control advocates have a point when they argue that guns make it a heck of a lot easier for evil people to kill others. The same is true for options: Reckless investors can lose 80% of their investment in options much faster than they can in stock. But, hey, most people aren't evil, and most investors (especially Fools) aren't reckless. Fools invest intelligently, whether in stock or options.
Options basics
The first thing to know about options is that they can be used to replicate a stock position but with a lower margin requirement. (Margins mean you buy stock by borrowing money from your broker.) What's not to like? Everyone should be in favor of options that allow one to buy stock at a lower cost. According to Tom Preston, director of quantitative strategies at the Thinkorswim options brokerage, "In terms of risk, there is no difference between synthetic stock and actual stock." (The link opens a PDF file.) The formula equating stock to options is as follows:
Stock = long call plus short put (a.k.a. an options "combo")
Take, for example, a stock like Apple Computer (NASDAQ:AAPL), one of five stocks with the most actively traded equity options in September. (You could use other stocks with actively traded options, such as Inside Value picks Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), and Pfizer (NYSE:PFE), but I'm an avid user of a video iPod, so I'm psyched about Apple.)
Let's assume you want to own 100 shares of Apple stock. With the stock currently trading at $81.50, you could simply buy 100 shares for $8,150. Or you could buy one December $80 call for $5.15 and sell one December $80 put for $3.10 for a net cost of $2.05 ($5.15 minus $3.10), resulting in a share-equivalent cost of $82.05 ($80 strike price plus $2.05). If the stock price falls below the options strike price when the option expires, you need not close out the position -- you could simply allow the short put to be exercised against you and you could then take possession of the stock. Buying the stock outright via option assignment is not, of course, your desired solution, since you'd enter the option combo position only if you expected the stock to go up, in which case the put would expire worthless and not be exercised. If, however, you end up in possession of stock through an options assignment, you're no worse off than if you had just bought the stock in the first place.
Yes, the options combo replicates owning Apple stock at a per-share price that's $0.55 more expensive than the straight stock purchase, but this is offset by the interest earned in your brokerage account over two months because you didn't have to shell out the full $8,150 for the stock position. Most importantly, the straight stock purchase has a margin requirement of $4,075, which is more than double the option combo's margin requirement of only $2,000. Lower margin means that you can put more money to work ($4,075 - $2,000 = $2,075), generating returns elsewhere. The only downsides to the options combo are commission costs and execution speed. Commissions for trading two options can cost more than for trading one stock, and stock can sometimes be traded faster than an options combo. But these cons only apply to short-term traders, not long-term Foolish investors.
Reducing risk
But options offer investors much more than simply the ability to mimic stock. Options give investors a means to reduce the risk of owning stock. Let's say you already own 100 shares of Apple. With the stock at $81.50, your position is worth $8,150. You have no downside protection, meaning that if the stock goes to zero, you lose the entire $8,150. If, however, you were to buy a April $80 put for $6.60, you would still enjoy all of the stock's upside appreciation (except for the cost of the put), yet your maximum loss would be capped at $810, which is slightly more than the $660 cost of the option ($6.60 times 100 shares per contract). Hmmm ... which is more risky -- a potential loss of $8,150 or a loss of $810? You buy insurance on your house and on your car. Why wouldn't you buy insurance on your investment portfolio?
And here's the cool part: The risk of owning stock plus a put option is identical to ... a call option! Yep, that's right, the much-vilified call option is a safer play than owning stock. And buying a call option has a lower margin requirement to boot. For example, the margin requirement on an April $80 call is simply the cost of the call, which is $9.95 per share or $995 per contract, while the stock plus put has a margin requirement almost five times higher, at $4,735.
So how did the call option get such a bad rap? Well, it has to do with percentages. Option gains and losses are leveraged, meaning they're larger than those of the underlying stock. For example, if Apple stock were to lose $20 a share, the stock would go down only 24.5%, whereas an April $80 call option currently trading at $9.95 would fall to $1.65, which is a much larger 83.4% decline. But wealth is determined by dollar amounts, not percentages. I'd rather lose $1,660 (($9.95 - $1.65) times 100 shares per contract times two contracts) owning two options down 83.4% than lose $2,000 owning a stock down 24.5%. And don't forget that the upside favors options over stock as well. If Apple stock were to gain $20 a share, the stockholder would make only $2,000 on a 24.5% gain, whereas the options holder would see the two options skyrocket 151% from $9.95 to $25 and reap a profit of $3,010. It's pretty cool that option holders lose less on the downside than they make on the upside for the same size move in the stock! This beneficial asymmetry occurs because options possess gamma, something stock does not. (The link opens a PDF file.)
Traders get into trouble with call options because they buy many more contracts than necessary to mimic the profit potential of stock. For example, if you'd normally own 100 shares of stock, it takes only two at-the-money call options to let you fully participate in the stock's upside potential. But reckless traders don't stop at two. They figure if they have $8,150 to invest in Apple stock, they should purchase as many call options as possible with the full $8,150. This is insanity -- the leverage of options should be used to reduce the risk and margin requirement of stock ownership, not to maximize profit potential at the risk of complete loss.
The other problem with buying call options is that their cost often includes a large slug of time value, which has the bad habit of disappearing with time decay (something from which stock does not suffer). However, time decay can be minimized if you own only options that have at least 45 days until expiration. I talk about time decay in my "Be Your Own Casino" options series, where I recommend selling option credit spreads that have time decay work in your favor, while still limiting your risk below that of owning stock. And the beauty of credit spreads is that they can be structured to make money whether a stock goes up, goes down, or stays the same.
Foolish bottom line
So to summarize: (1) A combo of a call and a put option can mimic the risk profile of stock but with a much lower margin requirement; (2) a call option has the same risk profile as stock protected by a put option, but at much lower cost; (3) call options can provide investors with all of the upside appreciation of stock but with much less risk; and (4) selling option credit spreads allows investors to harvest time decay with limited risk and profit even when the market goes nowhere.
Some may ask whether options are beneficial to investors. The answer, in my humble opinion, is a slam-dunk yes. The real question for me is this: Why would anybody increase his or her risk and waste margin to own stock?
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Fool research analyst Jim Fink spends all day researching stocks but wishes he was trading options instead. He has no financial interest in any of the companies mentioned but does hold a brokerage account with Thinkorswim. The Motley Fool has an ironclad disclosure policy.
