Millions of investors never bother to take their investing strategies beyond owning stocks and mutual funds. Although that simple method is enough for many to reach their financial goals, using it will make you miss out on a tool that can not only enhance your profits but also help you control the risk level in your investment portfolio.
The key tool is the stock option. Options have gotten a bad name over the years, thanks to some questionable practices in the boardrooms of some of the top companies in the nation. But many investors misunderstand just how useful options can be not only for letting you get more bang for your buck but also by helping you protect your stocks from unexpected losses.
Throughout the week, I'll be taking a close look at options and the strategies you can use with them. First, though, let's take a look at why many investors avoid options and get some of the basics under our belts.
Why everyone hates options
Options have a bad reputation because they're inevitably wrapped up in the larger story of executive compensation. Whenever you hear about CEOs who receive huge pay packages from their employers, odds are good that much of that money came from grants of stock options. Last year, Ford's (NYSE: F) Alan Mulally, Mel Karmazin of Sirius XM Radio (Nasdaq: SIRI), and Starbucks (Nasdaq: SBUX) CEO Howard Schultz were among those called out for massive stock option grants in 2009 that had skyrocketed in value in the ensuing months.
As if that weren't enough, some companies faced allegations that they adjusted their options grants to increase profits for executives even further. The practice of options backdating involved companies resetting options grants to reduce the price that executives would eventually have to pay for shares. In the scandal, companies as diverse as Apple (Nasdaq: AAPL), Home Depot (NYSE: HD), and KB Home (NYSE: KBH) faced questions about whether their executive stock options were proper. Former Brocade (Nasdaq: BRCD) CEO Greg Reyes received an 18-month jail sentence after a court found him guilty of charges arising from options backdating.
Conversely, the other way that investors see options is as a way to make high-risk bets on share movements. Options can rise and fall dramatically even with relatively small percentage moves on the underlying stock. That makes options a favored play for speculators.
The smarter way to use options
But options aren't inherently sinister, nor are they only useful for speculators. You can use them for a variety of ordinary, legitimate purposes, including the following:
- To protect your portfolio from big drops in individual stocks or the broader market.
- To get exposure to stocks while putting less of your capital at risk.
- Generating income from stocks that don't pay dividends, or enhancing your payout from stocks that do.
- Hedging the risk from a big piece of news or a one-time event that you expect to make or break a company.
Later in the week, we'll get into more detail about the ins and outs of the strategies behind these goals and how to put them to good use.
But for now, your key takeaway should be that options are only as risky as you make them. It's definitely true that options are risky and typically involve the potential loss of most or all of what you invest in them. But if you use options in moderation, you can minimize those risks while still putting you in the best position to profit if the markets move your way.
Keep your options open
So before you dismiss options as only a wealth-making opportunity for rich CEOs, take a closer look. Once you understand all the ways that ordinary investors like you can use options to your advantage, you'll realize that having a whole new set of investing tools can help you enhance your long-term returns without nearly as much risk as you might think.
To learn even more about options, be sure to check out our Options Center. You'll find a tutorial on options and much more.
