Are Options an Option?

In the movie Two for the Money, Matthew McConaughey plays a hotshot sports bookie with an uncanny knack for picking the winning team. But his picks eventually go south, leaving his clients understandably angry. One desperate client ends up calling him from a desolate phone booth, screaming, "I had a life!"

Consider this fair warning, Fool. There's a valid case, if not necessarily a Foolish one, for employing call options as part of your overall portfolio. But if you make options the core of your investing strategy, that guy in the phone booth could be you.

Options are a type of derivative. That means you're not actually buying securities -- just a contract that gives you the option to acquire a security at a specified price for a specified period of time. In investing, it's important to remember that you should never stake "what you have and need for what you want." When you buy options, the money you spend has to be money that you're prepared to lose, because that's a likely outcome. Often, buying options doesn't work.

Know your risks
There are three somewhat formidable hurdles to overcome when using options: time, direction, and magnitude.

Time means that options have finite lifespans. When you buy a stock, you can ride out the roller coaster as it dips lower, then hopefully ramps higher. When buying a call option, the roller coaster can be taken right out from under you. As options creep (more like sprint, if you're holding them) closer to expiration, time premium is lost, and the option loses value. After expiration, they cease to exist altogether.

Direction is fairly obvious. You buy a call option to speculate that a stock price will go up past a certain price -- the "strike price." If it goes down, or generally moves sideways, your option usually expires, leaving you with nothing to show for it.

Magnitude is a little more complex, but it basically entails knowing how much a stock will rise when buying a call. To win with call options, you have to correctly predict time, direction and magnitude -- a tall order in a world where picking equities is hard enough.

Even Warren Buffett has called the use of derivatives "toxic." Indeed, options can be a potential minefield for beginning investors who don't understand the risks involved.

The right time for options
But there are situations in which using options makes sense. For instance, suppose you really want to participate in an idea -- for example, an upstart drug company, or a manufacturing company whose small product could be picked up by major retailers. If that drug company does not plug its pipeline, or big retailers decide to duplicate the product rather than stocking the original, disaster could strike, and shares might plummet. In investing parlance, these black-and-white situations are usually referred to as binary outcomes. They work -- "one" -- or they don't -- "zero." As Buffett says, anything times zero is, well, zero!

If that zero outcome is too much to bear, but you think the stock might really go up, you could consider buying a call option. It'd let you participate in the upside while limiting the potential downside. Buying options allows you to amplify your payoffs while clearly defining your losses.

Let's take the example of that one-hit-wonder drug company. Suppose it's currently trading at $10 per share, with a chance to go to $20 if the FDA blesses its promising new product. So you buy an option that costs $2, expires in one year, and has a strike price of $10. Lo and behold, the drug gets approved, and the stock shoots up to the top end of your expectations. Your profit would be the stock price of $20, less the strike price of $10 and the $2 purchase price for the option. Commission charges aside, you'd snag a profit of $8 per share. (To simplify this example, I'm dealing with single options, but you should know that they're generally sold in lots of 100.)

We'll start with the obvious question: If there are so many potential pitfalls involved with options, why use them at all? If the underlying price of a security rises beyond the strike price, couldn't you have made a greater profit by actually owning the stock anyway? Yes, absolutely -- if you had bought the stock, you could have reaped $10 in profit instead of $8.

But consider this. Owning a stock requires you to risk more capital to get a payoff. In the case of the call option, you risked $2 to make $8 -- a 300% profit. Had you bought the stock outright, you would have needed $10 to make another $10 -- a 100% profit. While you would have made more money buying the stock, you'd have had to risk disproportionately more of your capital to do so. Buying calls allows you to risk someone else's capital; in return, however, you risk time, magnitude, and direction.

Real-world options
Certainly, there are plenty of ways you could have made money by owning options over the past nine months. Here are just a few:

• The recovery in financials like Citigroup (NYSE:C), Bank of America (NYSE:BAC), and Goldman Sachs (NYSE:GS) created huge gains for shareholders, but even larger ones for buyers of options.
• Similarly, while many were betting that casino stocks such as MGM Mirage (NYSE:MGM), Wynn Resorts (NASDAQ:WYNN), and Las Vegas Sands (NYSE:LVS) would go into bankruptcy, investors who bought call options laughed all the way to the bank.
• Technology names such as Google (NASDAQ:GOOG) have seen some impressive gains this year. But while Google shares are expensive, options let investors get in with much less capital -- and their gains have been even bigger in some cases.

For many investors, the situations these companies faced made them too risky to buy shares. But by buying options, investors stayed in the game, limiting their downside but providing a potentially lucrative participatory route.

Again, don't be the guy in that phone booth! Approach options with caution, and if you don't understand the risks, stay away entirely. However, if you can appreciate and respect the power of this commonplace derivative, it can prove a valuable tool in creating disproportionately powerful payoffs in the public marketplace.

Now's a great time to learn more about options. Our Motley Fool Options team offers a hands-on approach to options investing that will help you get smarter, make money, and have fun along the way. Want to learn more? Just put your email in the box below.