Many investors have successful investing careers without ever once looking at options. Given the wide variety of stocks, bonds, mutual funds, exchange-traded funds, and other investments available, you can easily come up with investing strategies that will put you on track to reach your financial goals even if you never have a single option in your portfolio.
And yet options can truly help you achieve your financial dreams. By letting you establish the precise level of risk you're willing to take in your investments, options can help you adapt to changing market conditions without having to make massive course corrections in your portfolio over and over again.
Still, many people are convinced that options are just another trick that Wall Street brokers use to separate you from your money. Let's take a look at how people misuse options and then introduce four basic strategies that, when used correctly, can actually reduce risk levels in your portfolio.
Why options scare some investors to death
Many investors avoid options like the plague for what they see as a very good reason: Those who buy options often lose every penny they pay for them. Unlike shares of stock, which only rarely suffer complete losses, options routinely expire worthless. That gives them a reputation for being dangerous.
At the same time, many options advocates point to specific options strategies designed to resemble get-rich-quick schemes. It's true that if you buy options at exactly the right moment, you have the potential to enjoy gains that greatly exceed anything you could achieve through owning shares of stock. The most obvious example is buying options immediately before a company receives a takeover bid. In such situations, a stock price might double, while options might jump in value by 100 times or more. Although the promise of potential riches attracts certain short-term traders, it puts off long-term investors who know better than to think that they can count on such ideas to pay off with any regularity.
What too many investors never realize, though, is that there's an alternative to swinging for the fences and striking out 99 times out of 100. Rather than standing on their own, most smart options strategies integrate the options you buy or sell with other positions in your portfolio. By using options this way, it's a lot easier to dial the risk level of your portfolio up or down however you want.
Four options strategies to consider
Options have almost infinite flexibility. With hundreds of different stocks, ETFs, and other investments offering options with a multitude of different expiration dates and strike prices, investors can tailor their choice of options with great precision. Moreover, the options that one speculator might use to bet on an unlikely event are the same ones you might use to control risk and enhance your portfolio's profitability.
One common options strategy involves what are known as covered calls. With this strategy, you sell call options on shares of stock that you already own, accepting the payment for the option as an income-enhancing method in exchange for giving up some potential upside. That payment is yours to keep no matter what the underlying stock does, and even if the stock climbs high enough for the option buyer to exercise that option, you'll end up selling your shares at the price you selected -- which many often choose at a significantly higher level than where they opened the position.
Conversely, you can write put options. Puts give the option buyer the right to sell you stock at a predetermined price, and again, you'll get paid an upfront amount to take on the obligation of buying shares. Often, investors choose bargain prices at which they'd be tempted to buy the stock anyway, and for them, put-option income is just gravy.
The other two major options strategies involve buying options. Many investors buy as many call options as they can afford to bet on a big jump, but you don't have to use leverage to open a call-option position. Instead, a modest call-option portfolio gives you exposure to stocks or other investments without putting as much money at risk.
Finally, buying put options on stocks that you already own can give you full or partial protection from share-price declines. You have to pay a price for that protection, but for many investors, even temporarily preserving their profits can be worth that price.
What each of these four ideas shares is that none of them is inherently a high-risk strategy. If you emphasize controlling risk rather than taking extra risk with options, then you'll find that you're more likely to make money and less likely to get fleeced by a professional trying to take advantage of your inexperience.
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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.