Know Your Options

"TANSTAAFL! (There Ain't No Such Thing As A Free Lunch)"
-- Robert A. Heinlein, The Moon Is a Harsh Mistress

Individual investors are often warned about employing options in their portfolios. Then, as time passes, they may hear tales of stunning option profits -- many times the returns they're seeing on their stocks. With every early-morning infomercial highlighting options millionaires, the siren song grows louder.

Should you use options? Indisputably, options strategies can offer tempting gains. But investors shouldn't gloss over the potential pitfalls of options and let greed overrun a sound long-term investing strategy.

So, let's look at some good reasons to fear options.

The basics
A call option is the right, but not the obligation, to buy a stock at a set strike price before a specific expiry date. A put option is the right to sell a stock at the strike price before expiry.

As with stocks, investors using puts or calls can take a long position, meaning they buy the option, or a short position, meaning they sell the option into the market. Options are sold as contracts; each one controls 100 shares.

Options as leveraging assets
One axiom of finance is that greater reward comes at a cost of greater risk. For options, the greater potential rewards come with the greater risk of leverage.

As a simple example, let's look at a call on Nokia (NYSE:NOK) expiring in January 2011. We'll assume we have $1,000 to invest in our simple portfolio.

With our $1,000, we could buy 74 shares outright for $987.16 or three 100-share call contracts at a cost of $320 each ($960 total).

Now let's look at what will happen if Nokia rises to $18 by expiration.

If we simply bought the stock, our 74 shares would be worth $1,332. Including the un-deployed cash, our total portfolio return is about 35%.

With the Nokia options alternative, our immediate payoff would be $1,650 (300*($18-$12.50)). Add back the un-deployed cash, and the options portfolio laps the equity portfolio with a 69% return.

Right now, you probably want to know where to sign up. But remember: There ain't no such thing as a free lunch. Greater rewards can have substantial costs.

How to drain your capital
What if Nokia doesn't do as well as we expect and only gets to $15 by option expiration? In that case, our shares-only portfolio sees a period return of 12.3% (including our extra cash).

However, the options portfolio suffers a stiff blow -- the options would be worth $750, and the portfolio sees a 21% loss.

Further, if the stock falls to $12.50 at option expiration, the equity folks are sitting on a mild loss, while the options expire worthless and the associated portfolio chalks up a 96% loss of capital.

Before becoming an options investor, you'd best ask yourself how often you're willing to take such losses.

Another (small) hurdle
Small caps are historically more volatile than the broader market (notwithstanding the last year we've all lived through), and that makes it difficult to consistently employ a winning options strategy.

Yet your options profit potential is not much enhanced by focusing on less volatile, larger companies:

*Probability the option finishes in the money.
**Probability the buyer ends with a profit.

There are three takeaways from this table:

1. The shorter your investment timeline, the harder it is to make money reliably. In this table, we're looking out no further than January 2010.
2. Although Blackboard is more volatile (looking backward) than is Verizon, United Tech, or AT&T -- and higher upside volatility can be the friend of the option holder -- the probability for making money is not appreciably better. In other words, options markets are efficient.
3. The probability of making a profit in these options is about 4 in 10. These dismal short-term chances should have you questioning whether it's good to jump in here.

The problem with buying an option is that you have to be right twice: You need to first find a good company trading at a good price, and then you have to be right on the timing.

An investor in Home Depot (NYSE:HD), whose stock price has famously gone nowhere for years, at least owns the future potential gains of the stock (it has to start up again sometime, right?). But a buyer of Home Depot $25 January 2010 call options a year ago is sitting on a rapidly depleting asset.

Then again, options investing is about trade-offs (no free lunches, remember), and had that investor bought those same options at the March lows (remember, with options, timing matters), he'd be singing a happier tune today.

The Foolish bottom line
So should you forget about options altogether? Well, in business school I learned that the answer to any question is: "It depends." (And by telling you that, I've just saved you the cost of an MBA!)

There are situations where using options can make sense for the Foolish investor. If you want to find out more about what they are, take a look at Jeff Fischer's educational video series on options.