From Motley Fool Pro: Options 101

Why Options?

Many investors approach options with skepticism and caution – some simply refuse to even consider them. That's not entirely unreasonable – you don't need to use options in order to be a successful investor. Even I believed for a long time that options were not a Foolish way to invest.

But as I began to learn more about options, I discovered that they are excellent tools for generating income, protecting profits, hedging, and, ultimately, earning outsized gains. Eight years ago, I took the plunge and started using options alongside my stock portfolio. I've found that options can generate returns in flat markets, cushion the blow of down markets, and be outstanding performers in decent markets.

Whatever your investment goals, options can be a powerful addition to your portfolio. Option strategies are an important element of Motley Fool Pro, where we use them to hedge, to short, to produce income, and to obtain better buy and sell prices on our stocks. What's important to know is that we trade options as investors, not as speculators. Any option trade should always be taken based on thorough analysis of the underlying stock and its value. That way, the option is simply a way to leverage what you know about a stock.

What Are Options?

Stock options formally debuted on the Chicago Board Options Exchange in 1973, although option contracts (the right to buy or sell something in the future) have been around for thousands of years.

Applied to stocks, an option gives the option holder the right, but not the obligation, to buy or sell an underlying stock at a set price (the strike price) by a set date (the expiration date). The option contract allows you to profit if a stock moves in your favor before the contract expires. Not all stocks have options – only those with enough interest and volume.

There are only two types of options: calls and puts. A call appreciates when the underlying stock rises, so you buy a call if you are bullish on that company. A put appreciates when a stock declines. You buy a put if you believe a stock will fall or to hedge a stock that you already own. One way to remember this is: "call up; put down" (as in, call something up, or put something down).

Next, let's walk through the most common options trades we make in Pro: buying calls, buying puts, selling covered calls, and selling puts.

Buying Calls

Investors often buy call options rather than buying a stock outright to obtain leverage and potentially increase returns several-fold. Call options work as "controlled" leverage, enhancing your possible returns while limiting your potential losses to only what you invest (which is usually a much smaller amount than a stock purchase would be). Because each option contract represents 100 shares of stock, an investor can control – and benefit from – many shares of stock without putting a lot of capital at risk. When you make the right, er, call, you'll enjoy higher returns than you would have if you had used that money to buy the actual shares.

Let's look at an example. Imagine that a stock that you know well has been hit hard and now trades at $27 per share. You believe the shares will rebound in the coming months or year. The market offers $30 call options on the stock that expire in 18 months for $1.50 per share. Therefore, 10 contracts, representing 1,000 shares of the stock, will cost you $1,500 plus commissions. This option contract gives you, its owner, the right to buy 1,000 shares of the stock at $30 any time before expiration.

If your stock starts to rise again, your options will increase in value, too. Suppose the stock recovers all the way to $32 after a few months. Your option's value would likely at least double to $3 or higher per contract. You've made 100% in a few months. If you had simply bought the stock, you'd only be up 18.5%.

Of course, there is a flip side. Suppose your stock continues its decline to the abyss. Even 18 months later, it's below $20, so your options expire worthless – though hopefully you sold them at some point along the way to recoup part of your investment.

At Pro, we typically buy longer-term call options on well-valued stocks that we believe will reward us – and you! – handsomely over the coming months or years. It's a way for us to take more meaningful positions in stocks we believe in, without risking mounds of capital. This is useful if you're lacking capital or just don't feel like risking it all in a stock.

As with any investment, you should only invest what you can afford to lose, since a stock can easily work against you in a set amount of time and make your call worthless. Where real opportunity is lost is when your timing is wrong. Your options might expire before the stock rebounds, causing you to lose your option money and miss the stock's eventual rebound. Thus, we aim to buy longer-term calls in positions in which we have high confidence and near-term catalysts.

Buying Puts

Next up, the antithesis to call options: puts.

We buy put options when we believe that the underlying stock will decline in value. Buying puts is an excellent tool for betting against highly priced or troubled stocks, or even entire sectors! With put buying, your risk is again limited to the amount that you invest in stark comparison to traditional short selling, where your potential losses are unlimited. Ouch!

Aside from betting against a position with puts, we may also buy puts to protect an important position in our portfolio, one that we don't want to sell yet for any number of reasons. When a stock being protected – or hedged – in this way declines for a while, the puts will increase in value, smoothing out returns.

Pro will buy puts on stocks that we believe are due to decline over the coming months or even years. We may also use puts to hedge long positions that we own, or to short sectors and indexes in a small portion of our portfolio. We'll almost always buy puts rather than short something outright to limit our risk – and yours.

Selling Covered Calls

Now our overview moves from the act of buying options to, instead, selling them to others.

Any qualified investor can "sell to open" an option contract. When you do so, you don't pay the premium; instead, as the contract writer, you get paid instead. All cash generated from your option selling is paid immediately and is yours to keep.

Do we have your attention? We thought so!

The call options that we write (or sell) in Pro are covered calls. "Covered" simply means that we own the underlying stock at the same time. Writing covered calls is one of the most conservative options strategies available. In fact, most retirement accounts allow you to write covered calls. They're generally used to generate income on stock positions while waiting for a higher share price at which to sell the stock.

Here's an example of a covered call. Suppose you own 1,000 shares of a stable, blue chip stock. It's trading at $56, but you think it is fairly valued around $60 and you would be happy to sell at that price. So you write $60 call options on the stock expiring a few months ahead, and you get paid upfront to do so.

If the stock does not exceed $60 by your option's expiration, you keep your shares and you've made money on the call options. You could then write more calls if you wanted to. If the stock is above $60 by expiration and you haven't closed out your call option contract, you'd sell your stock at $60 via the options. Your actual proceeds on the sale would include the option premium you were paid. So you sold your shares at the price you wanted to and received some extra cash for doing so. That's pretty sweet.

So, write covered calls when:

• You would sell a stock that you own at a higher price, and you're not worried about it declining too much in the meantime. Write calls at your desired sell price, collect the dough, and then kick back and wait. Rinse and repeat, month after month when you can.
• You believe a stock you own is going to stagnant for a while, but you don't want to sell it right now. Write calls to make the stagnation more profitable.
• You want to cushion a stock that is in decline, but that you're not ready to sell yet. Tread carefully here so you don't get sold out at too low a price.

When you write covered calls, you must be prepared to give up your shares at the strike price. Approximately 80% to 90% of options are not exercised until expiration, but they can be exercised early, so the call option writer has to be prepared to deliver the shares at any moment.

That means that if the $56 stock in the example above suddenly soars to $70, you'd still have to sell at $60. This is the biggest downside to covered calls -- lost potential if a stock price rises. The other risk is that a stock may fall sharply after hovering around your desired sell price for a while, forcing you to wait longer for your sell price.

Even though covered calls are low risk, we'll still use them only on stocks we know well. We may even set up some covered-call only positions – buying a stock just to write calls on it.

Selling Puts

Note: to sell puts, you must have a margin account. You won't actually need to use margin – which entails high risk – but you must be margin-approved, have ample buying power (cash, in our margin-free strategy), and have full options permission from your broker.

Selling puts – also referred to as selling naked puts -- is a favorite strategy of mine to seed a portfolio. There may be plenty of stocks that we'd like to buy at the start, but we'd prefer to snag them at lower prices. Put options are an excellent way to potentially buy a stock at your desired, lower share price and get paid an option premium while waiting for that price, whether it arrives or not.

Let's turn to an example: A top-rated stock we found on CAPS and researched thoroughly is trading at $39, but our analysis suggests that we shouldn't buy it above $35. The $35 put options expiring four months out are paying $3 per share. We "sell to open" the put contracts and get paid $3 per share to make the trade, giving us a potential net purchase price of $32 before commissions. A few things could happen here.

Scenario 1: The stock could stay above our $35 strike price, and the options we sold expire. We didn't get to buy the stock at the price we wanted, but at least we made money on the options we sold.

Scenario 2: The stock could fall below $35 by expiration. In this situation, our broker would automatically buy the stock for our account, giving us a start price of $32 before commissions – even lower than our $35 desired buy price!

Scenario 3: The stock may tank to $29 soon after we sell the puts, but then climb back above $35 by expiration. In this case, we most likely would not have had the shares sold to us during this brief decline because about 80% of options are exercised only at expiration, not before. So we won't own the shares and we'll have missed our buy price and the stock's rebound -- but we did get paid the premium, at least, and can try again.

Scenario 4: The company's CEO flees to Bermuda and the stock is only at $16 by our option's expiration. We didn't have the heart to close our losing option position, and we still have hope, so we wait and the shares are "put" to our account at $35 (minus our option premium) upon expiration. This is the worst-case scenario -- we're down 50% to start. But we own the stock now and can hope it rebounds. Of course, assuming that we would have bought the stock outright when it hit our $35 buy price, as we had considered, we would be down even more than we would be with this strategy.

In Pro, we will most often sell puts when a stock we follow closely and want to own is, alas, above our desired buy price. We'll sell puts on it at lower strike prices, prices that we believe are great levels at which to buy. Either we'll eventually get to buy the stock at our desired price via the puts, or we'll keep writing puts if the situation merits it. We may also sell puts when a stock we already hold a partial position in is above the price where we'd like to buy more. We'll write puts as we wait to average in at lower prices. This is a great tool for allocation and averaging into a position.

Writing puts on stocks you know well and want to own at lower prices can be an excellent tool for income and for securing lower buy prices, but you must be prepared to buy the stock should it fall below your strike price. At all times, you must maintain the cash or margin (for us it's always cash and we recommend you follow that rule, too) to buy shares if they are put to you.

It's important that you only write puts on stocks that you understand well and will be happy and ready to buy at the prices you're targeting. The risks of writing puts include the fact that the stock could soar away without you. In many cases, it's better to just buy a great stock once you've found it. The other risk, of course, is that a stock falls sharply and you're stuck owning it. The biggest risk with selling puts, as with all options, is when investors use rely on margin instead of cash. That can quickly wipe out a portfolio.

Broker Requirements

Conclusion

Our Options 101 overview is just that: a brief introduction to options and basic option strategies. Options are volatile, often moving with much more severity than the underlying stock, and they can present great risk to uncertain investors, as well as great reward to those with steady strategies who have done their research on the underlying stocks – as, of course, we always do at Pro.

We use options to capitalize on our business-based, valuation-centric investment approach and enhance our returns. In your own portfolio, you can use options alongside us to improve your performance and expand your possibilities. 

If you are interested in receiving more information from The Motley Fool about investing in options, please click here. And be sure to stay tuned for more options content from the Fool in the days and weeks to come.