Most investors are somewhat familiar with equity options. Equity options are simply rights to buy or sell the underlying stock at a certain price within a specified period of time. Options can be quite risky and are best left to experienced or well-capitalized investors. However, when properly understood and prudently used, options can offer excellent returns with excellent risk/reward profiles.
I'll briefly illustrate the basic workings of a stock option with a real example. Consider Home Depot
The simple (and dangerous) math
Instead of purchasing 1,000 shares of Home Depot for around $26,000, an investor decides to purchase the January $30 calls at $15 each, getting about 1,733 contracts representing 173,300 shares. At expiration, Home Depot shares are trading for $32. A stock investor is sitting on a profit of $6,000, or a 23% gain. The option contracts are worth $200 each because they each convey the right to buy 100 shares of a $32 stock for $30. Thus the 1,733 contracts are worth $346,600, or a sizzling 1,233% gain!
It is these types of numbers that attract exactly those individuals who should stay away from options. First, my example is highly exaggerated. It assumes that Home Depot shares could rise 23% in one month. Sure, this is possible, but the likelihood is very low. This is because Home Depot has very little price volatility. The more volatile a stock's price is, the more expensive its underlying stock options will be.
Consider First Marblehead
The prudent way: LEAPS
Now that you can see the severe capital impairment that options usually cause for most investors, there is one option that offers investors the opportunity to exploit options' advantages while attempting to minimize their disadvantages. Options exist for a finite period of time. It is this timing that tends to wreak havoc on the option owner. The shorter the lifespan, the "cheaper" the options, but that means less time for the underlying stock to do its thing. Conversely, a longer lifespan gives more time for the stock to perform, but it will cost you more.
LEAPS stand for Long-Term Equity Anticipation Securities. Basically, they are long-term equity option contracts. LEAPS are typically two to two-and-a-half years in duration. So, rather than having a month for a stock to play out, you are given considerably more time.
When used prudently and intelligently, LEAPS can offer an opportunity to invest in a business with a lower initial cost of capital. I cannot emphasize the importance of participating in LEAPS only after you understand the advantages and disadvantages. Every day that goes by means the value of your option is declining at an accelerating rate. The two-year window that LEAPS offer, however, provides investors with opportunities to take advantage of stocks in out-of-favor industries that are due for a recovery. For instance, I believe homebuilders like Toll
In most situations, options investing should be avoided. It's a game of leverage where the odds are usually stacked high against you. I also believe that certain characteristics must exist in a business before the possibility of investing in it via long-term options should be considered. These specific characteristics should be understood fully before committing capital. In part 2 of this piece, these characteristics will be discussed in greater detail.
- The Death of Berkshire Hathaway?
- E*trade Bailout Signals Trouble Ahead
- One Fool's Best Stock Tip for 2008
Home Depot and First Marblehead are Inside Value recommendations. First Marblehead is also a Motley Fool Hidden Gems pick.
Fool contributor Sham Gad runs the Gad Partners Funds, a value-centric private investment partnership. He has no positions in the companies mentioned. The Fool has a wise disclosure policy.