The Truth About Options

The Truth About Options: Buying Puts & Calls On Stocks

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, December 15, 2008: Issue #901

Readers often ask me the truth about options and the advisability of buying puts and calls on stocks.

Let me begin by saying that options are tools, nothing more. Tools can be used to build something. Or they can be used to tear something down.

The key is to understand and master your tools and, more importantly, not destroy wealth when your intention is to create it.

Let’s start by defining our terms…

The Difference Between Put & Call Options?

Here are the differences between put and call options:

A put option gives the owner the option of selling a stock at a specific price, again known as the strike price, over a given period of time.

A call option gives its owner the option to buy a stock at a specific price, known as the strike price, over a given period of time.

The key advantage of buying options is that it allows you to control a large amount of stock for less money than it would cost you to buy the underlying shares.

If the stock moves up rapidly in a short period of time, your percentage gain in the call options will be much larger than if you had bought the shares.

By the same token, if the underlying stock suddenly falls off a cliff, your percentage gain in the put options will be much larger than if you had shorted the shares.

Under normal circumstances, however, few stocks move sharply in the near term. They tread water. They bounce around in a narrow range. Or they trend gently higher or lower.

When you have rare periods of extreme volatility – like the one we’ve experienced over the last three months – options become pricier, making it more difficult to score easy gains.

But the bottom line is this: The overwhelming majority of options expire worthless. Most people trading call and put options lose money.

Why Options Are Riskier Than Stocks

Why are options so much riskier than stocks?

With stocks, time is your ally.
With options, time is your enemy.

Built into the price of every option is a time premium. As time passes, that premium diminishes.

To make big money in puts or calls, the stock doesn’t just need to move in the right direction. It needs to make a sharp move in the right direction in a short period of time.

This is no easy trick.

And it’s exactly why selling options – collecting those premiums – is a conservative strategy, while buying options – paying premiums – is an aggressive one.

In the world of options, buyers are gamblers. Sellers are the casino.

Why Investors Continue To Use Option Trading Strategies

If the odds are long against long-term success with buying options, some might ask, why do so many investors continue to use option trading strategies?

Here’s an analogy …

If you’re a decent golfer playing a short par five, you may be tempted to go for the green on your second shot and give yourself a putt for an eagle.

The golf course architect knows this, of course. So what does he do? He puts a pond in front of the green and sand traps on both sides.

The smart thing – the percentage shot – is to just lay-up in front of the water and then chip on for a shot at a birdie.

Yet, often as not, the weekend golfer pulls out his three-wood or long iron and goes for the green. He realizes that his ball will probably end up in the cat box or the drink, but he goes for it anyway.

Why? Because if he pulls it off and makes an eagle, it will be the best thing he did all week. In short, he’s willing to risk it.

If it doesn’t pan out, well, what the heck, he knew the odds when he stepped up to the ball.

I guess what I’m saying is we’re all big boys and girls. Options are a “no-tears” investment. If you don’t understand this, you shouldn’t be trading them.

Puts and calls are neither good nor bad. They are simply tools.

Give a man a chainsaw and he’s likely to do some good work with it. Give it to a six-year-old and someone is likely to lose an arm.

Govern yourself accordingly.

Good investing,

Alex

P.S. This overview was woefully brief. If you’re interested in learning more about options, I suggest you listen to my friend and colleague Karim Rahemtulla, an options specialist. Sign up for his free e-letter The Smart Profits e-Report.

Today’s Investment U Crib Sheet

Investment U works hard to fill your toolbox with usable strategies and “tools.” In fact we’ve given readers a number of ways to use options:

Using covered calls investing can help you boost your bear market income. You can profit from the stocks you already own. Find out more about this two-step strategy in Investment U Issue #889, Covered Call Investing: How to Boost Your Bear-Market Income Right Now.

On the other hand, by selling puts, you can get paid to buy the stocks you want, at the prices you decide. This strategy pays you for waiting to purchase stocks. Learn more in Investment U Issue #882, Put Option Selling: Get Paid to Buy the Stocks You Want.

Before you make any investment, you need to ask a simple question: What If You’re Wrong? It will help you judge the risk you are taking. If you’re concerned there’s too much risk in options, stick to well-funded stocks. Or if you want to take advantage of the wining picks from our White Cap index, find out more about our White Cap Report.

One Response to “The Truth About Options: Buying Puts & Calls On Stocks”

finance guy Says:
March 2nd, 2009 at 9:20 pm
Every time i come here I am not dissapointed, nice post

Reply

Comments

**By submitting your comment you agree to adhere to our Comment Policy and Privacy Policy.

Check out our selection of daily Investment Research: