Trading options has become much more popular in recent years, and maybe you've started to notice. However, most casual investors understand very little about how options work and how best to use them.
Here are some basics on good and bad uses of options and whether you need them in your portfolio.
What is an option: The quick version
Simply put, an option gives you the right (but not the obligation) to buy or sell a stock at a predetermined price anytime before a set deadline.
Options are sold in "contracts" that cover 100 shares of stock each. "Call" options give you the right to buy shares, and "put" options give you the right to sell shares.
For example, if I buy one XOM Jan $100 call, it gives me the right to buy 100 shares of ExxonMobil for $100 apiece anytime before the January expiration deadline (usually the third Friday of the month).
Covered calls can lower your risk and give you income
There are two basic "good" uses of options trading: selling covered calls and selling puts.
Selling covered calls is basically a way to provide some downside protection in your portfolio while receiving some income as well. By selling a covered call, you are essentially giving someone else the right to buy your shares for a set price at any point before the option expires.
For example, if I own 100 shares of Apple (NASDAQ:AAPL), which is trading for about $109 per share as of this writing, I could sell a contract expiring in January that would allow the buyer to purchase my shares for $115 each at any time before expiration. In exchange for selling this option, I'll collect about $150 from the buyer -- this is known as the premium.
If the option expires and the shares are worth less than $115 (known as the "strike price"), I keep the premium, have no further obligation to the option buyer, and am free to repeat the process. On the other hand, if my Apple shares rise above that amount before expiration, the option will be exercised, and I'll be forced to sell my shares at less than market value.
Buying shares on the cheap: selling put options
Selling puts is a strategy to earn income and give yourself the chance to buy stocks you want to own for less than their current trading price. By selling a put option, you give someone else the right to sell you shares at a certain price.
Let's say I like Citigroup (NYSE:C), but I think it's a little overpriced at the current $54 share price. I could sell a put option with a $50 strike price expiring in January for $57. If shares stay above $50, I keep the premium and have no further obligation. On the other hand, if shares fall, I am obligated to buy 100 shares at $50, and I keep the option premium.
The risk is that if, for example, Citigroup plummets to $30 per share before January, I'm stuck buying shares for $50. The option premium is my compensation for taking on this risk.
Bad options trading is like gambling
The one thing investors should never do with options is to buy them outright -- especially with "out of the money" options. For instance, if I buy options that let me purchase Citigroup shares for $60 anytime before next June, I could definitely make a lot of money if Citigroup shares spike to $75, but it's much more likely that the options will expire worthless.
One popular strategy is to buy options that are in the money as an alternative to buying the stock itself. Since Apple is trading for about $109, I could buy an option contract with a $100 strike price, basically allowing me to capture all of Apple's upside above that amount.
This is just like buying stock, but with tremendous leverage. If Apple has a big upside move, I could multiply my investment several times over. However, if shares drop below $95 at expiration, my options will be worthless. On the other hand, by simply investing in the stock, I'm limiting my downside risk. In other words, no matter how bad things could get, Apple isn't going to zero or anywhere near it. Meanwhile, a risky options play could easily be completely wiped out.
You should probably keep it simple
In truth, most investors should stay away from options. While there are good uses for options in long-term investing strategies, there are many complexities involved, and they are best left to experienced investors.
Warren Buffett himself said that derivative instruments, such as options, are not necessary to produce market-beating returns, and he has proven that time and time again. With a portfolio of high-quality stocks and funds, your long-term performance should take care of itself. Unless you look at investing as your full-time job and have hours to dedicate to the craft every day, that's what you should focus on.