When you pull up the Fool's FAQ on stock options (the kind you can trade, not the kind given to employees), you see a very grim assessment of the things, so let me be blunt: Our almost entirely negative FAQ on stock options is due for a tweakin'. I'm not going to argue that options are a good thing for most people (they aren't), but they do offer experienced investors a few valuable strategies that aren't available otherwise.
Are you sitting there right now in disbelief, thinking, "Stock options are seriously being discussed on the Fool? Options trading?!"
Before any outrage, realize that we already explained option strategies in detail in our June and July 2002 issues of The Motley Fool Select, so it's too late to cry "foul." I don't think you'll need to, anyway. Options are a risky, statistically losing proposition, and most people should stay away. Our view on that doesn't change. But there are cases where experienced stock investors can consider options a smart strategy.
What are options?
Imagine you were God and you had to explain the entire universe to someone. Options are a little easier.
When you buy an option, you're buying the right (but not an obligation) to buy or sell a certain stock at a certain price within a specified time period. Buying a "call" option gives you the right to buy a stock at a set price and by a set time. Buying a "put" option gives you the right to sell a stock (assuming you own it) at a certain price by a set time.
You might remember which term is which by remembering that a "call" starts with "C," which is next to "B" for "buy." Owning a call gives you the right to buy. A put ("P") is closer to 'S' and is the right to sell.
Each option contract represents 100 shares of the underlying stock. If you buy one option on Microsoft (NASDAQ:MSFT), it gives you the right to buy or sell 100 shares of the stock at the option strike price. The strike price is simply the share price dictated by the option. A Microsoft put option with a $25 strike price gives you the right to sell the stock at $25 by the option's expiration date.
All options expire on a set monthly date, which is the third Friday of the month. You can buy options that expire this month, next month, and several months in the year ahead. You can also consider options called Long-Term Equity Anticipation Securities (LEAPS), which don't expire for up to three years when they're first issued, which is usually in July. If you're buying options, the longer-term ones are what we suggest you consider.
Why owning options is especially risky
When you own a stock option, several factors are working against you. First, the bid-ask spread is wide, so if you're buying and selling regularly (not at all advised), costs will eat you alive. Second, commissions are usually higher on options than for stocks. Third, options expire, so as their owner you're in a race against time. All else being equal, an option's value slowly decreases day by day. Finally, it's impossible for anyone to predict a future share price, let alone by a specific date.
Given all this, there are only a few instances where I can even begin to suggest options and still sleep at night. Before we get to the first instance, if options are new to you, do read the Fool's FAQ, because it certainly conveys the risks and dangers. Before reading it, you should know that there's strong disagreement to the widespread belief that 80% of options expire worthless -- studies show the figure at about 30%. Still, many options are closed out near worthless.
Finally, realize that you should only consider options if you've been investing in individual stocks for many years, deem yourself highly experienced, and have professional help on your taxes. And even then, consider them diligently, read a great deal (including the CBOE's Learning Center), and use paper-only (practice) options for months before using the real deal.
Now, let's consider one option strategy that isn't highly speculative but can be highly useful.
One option strategy: "Defense, defense!"
Today, we'll talk about a defensive option strategy. It's one that you might consider if you own a substantial position in an equity and want to protect its value. You may or may not actually wish to sell the stock in the intermediate-term (the next few years), but whatever the case, you want to protect your gains and are willing to pay something to do so.
In this case, you can buy a long-term put, which is basically like buying insurance for your shares. Here's an example: Assume you own 500 shares of eBay (NASDAQ:EBAY) and you've made substantial gains on the investment. You don't want to sell because you think there might be more long-term upside, but you realize that your risks at these prices are high. One misstep, and eBay shares could tumble.
One way to protect your gains without selling is to pay for a put option. Remember, a put gives you the right to sell the underlying stock at a set price in the future. Currently, January 2005 is the most distant month of options available on eBay. With the stock at $97, you can buy a January 2005 put with a $90 strike price for about $14 a contract. Each contract represents 100 shares, so this comes to $1,400 per 100 shares of eBay.
What you pay for an option is called a "premium." The more certainty an option gives you over the longer amount of time, the higher the premium. For instance, the ability to sell eBay at $90 over the next 20 months is a lot to ask from this volatile, highly priced stock. Anything could happen over that time, so you pay a high premium for the 2005 $90 eBay put. It's like insuring a Ferrari rather than a Hyundai.
Owning 500 shares, if you want to buy five contracts to protect them all, you'd need to pay $7,000 plus a commission (typically about $15 per contract, or $75). Now, $7,075 may sound like a lot, but if you're protecting $25,000 in gains, it could be worth it.
Once you own these puts, no matter what happens to eBay between now and mid-January 2005, you can sell your shares for $90 at anytime up until option expiration. If eBay keeps rising, your option will steadily go down in value, and if eBay ends January 2005 above $90, your option will expire without value. But meanwhile, your stock gained value and you had the security of knowing your "bottom" was $90.
It's like any insurance. Hopefully, you won't need to use it, but if you do, you have it. (In the same vein, you can see how the "most options expire worthless" argument is flawed, because with protective puts, you often want them to expire worthless.)
If eBay's growth were to slow too much and the stock tumbled in the next 20 months to $60, the price of your puts would concurrently rise from $14 to $30 by January 2005 ($30 being the difference between the $60 stock price and the put strike price, which is $90).
You could sell your puts and pocket the $8,000 gain, but then you'd still have the stock at $60. If you decide to sell your eBay, you would exercise your puts and sell your stock at $90, saving yourself a $15,000 paper loss at the cost of the original $7,000 spent on options. (And you could always then buy the stock back at $60 if you wanted to, with cash left to spare -- or just walk away.)
During the bull market of 1999 and early 2000, buying long-term protective puts paid off incredibly well. Today, there is obviously less need to protect large profits (except perhaps in cases like eBay), but during the next strong stock market (or when you have a stock soar), protective puts can be used to preserve your oversized gains when you aren't yet willing to sell a position.
Summary
Stock options are rarely the best choice for even an advanced investor (and should not be considered by anyone else), but they do have their place. I personally think buying options can be most useful when you have a large position to protect. Buying protective puts can make sense in investment circumstances where you prefer not to sell a stock yet, but you don't want to lose your gains and fear you could. The position needs to be large enough to merit the premium you'll pay to "insure" it. This is insurance, rather than investing, but sometimes buying insurance is smart investing.
Next week, we'll offer another option strategy that doesn't make us run away screaming -- one that may be more in tune with the down market. If you have questions or thoughts on options, feel free to ask.
Jeff Fischer owns a position in eBay and the Fool has a full disclosure policy, so what he owns is shown in his profile. This place is investors writing for investors.
