Know Your Options

"TANSTAAFL! (There Ain't No Such Thing As A Free Lunch)"
-- Robert A. Heinlein, The Moon Is a Harsh Mistress

Individual investors are often warned about using options in their portfolios without much explanation as to why. Then, as time passes, they hear tales of stunning option profits -- many times the returns they are seeing on their stocks. With every early-morning infomercial highlighting options millionaires, the Siren's song grows louder.

Subscribers to the small-cap Motley Fool Hidden Gems newsletter often ask, "Should I use options to buy recommendations?" After all, options strategies offer tempting gains. But most long-term investors should not gloss over the potential pitfalls of options and let greed overrun a sound long-term investing strategy.

First, let's look at some good reasons to fear options. Tomorrow, I'll try to explain how and when they might be used successfully.

The basics
A call option is the right, but not the obligation, to buy a stock at a set strike price before a specific expiry date. A put option is the right to sell a stock at the strike price before expiry. As with stocks, investors using puts or calls can take a long position, meaning they buy the option, or a short position, meaning they sell the option into the market. Options are sold as contracts; each one controls 100 shares.

Options as leveraging assets
One axiom of finance is that greater reward comes at a cost of greater risk. For options, the great potential rewards come with the greater risk of leverage. As a simple example, let's look at a call on Motley Fool Hidden Gems recommendation FARO Technologies (NASDAQ:FARO) expiring in March 2006. We'll assume we have $1,000 to invest.

With our $1,000, we could buy 50 shares outright for $990.50 or four 100-share contracts at a cost of $235 each ($940 total).

Got it? Let's look at what will happen if FARO's stock rises to $25 by the expiry date. If we bought the stock outright, our 50 shares would be worth $1,250. Add back the $9.50 we couldn't originally deploy, and our return is just shy of 26 %.

As for the options, our immediate payoff would be $2,000 (400*($25-$20)). Add back the $60 we were unable to deploy in this scenario, and options have paid off with a 106% return.

Right now, you want to know where to sign up. But remember: TANSTAAFL. Greater rewards can have substantial costs.

How to drain your capital
What if FARO doesn't do as well as we expect and never rises above $20? In that case, our comparison is slightly different. While our 50 shares would be worth $1,000 and we'd have a minuscule 0.95% return (after adding back our $9.50 cash), our option payoff would be zero, and the only cash we'd have left would be $60 -- a 94% loss of capital. Uh-oh. So before you become an options investor, ask yourself how often you are willing to suffer a loss such as this.

Small caps are historically more volatile than the broader market, and that makes it difficult to consistently employ a winning options strategy. Yet your options profit potential is not much enhanced by focusing on less volatile, large companies:

* Probability the option finishes in the money.
**Probability the buyer ends with a profit.

There are three lessons to take away from this table that are applicable to options and all investing:

1. The shorter your investment timeline, the harder it is to make money reliably. In this table, we're looking out no further than April 2006.
2. Although FARO is more volatile than Wal-Mart, Pfizer, or Cisco -- and higher upside volatility can be the friend of the option holder -- the probability for making money is roughly the same.
3. The across-the-board probability of making any profit in these options is dismal. When the odds are 6 in 10 that you'll see a short-term loss, pass. This is speculating, not investing.

The problem with buying a call option is that you have to be right twice: You need to first find a good company trading at a good price, and then you have to be right on the timing. In our second case, the stockholder has made a modest gain and still owns the future potential gains of the stock. The option investor has nothing but memories -- especially painful ones if FARO moves to $25 a month after the options expire.

The Foolish bottom line
Unless you have years of investing experience, financial knowledge, and competence valuing companies, don't consider using options. There are simply too many risks. In addition to the potential for dramatic losses, you're also forgoing the knowledge and business acumen you gain from following the companies you own.

Moreover, options should be viewed as nothing more than short-term side bets, not a viable long-term investment strategy. At Motley Fool Hidden Gems, analysts Tom Gardner and Bill Mann have beaten the market by nearly 20 percentage points by identifying superior small-cap companies and letting the wonders of compounding help subscribers build their nest eggs. To see the companies they've found and interact with the thousands of investors who are following these companies, consider a 30-day free trial. Always remember that if you own excellent companies, you will do well without options.

So should you forget about options altogether? Well, in business school I learned that the answer to any question is: "It depends." (And by telling you that, I've just saved you the cost of an MBA!) There are situations where using options can make sense for the small-cap investor -- but that is the subject for tomorrow's column.

Jim Gillies uses stock options to supplement his returns. (Hypocrite!) He owns shares in no companies mentioned and welcomes feedback.Pfizer is a Motley Fool Inside Value pick. The Motley Fool has a disclosure policy.