Are Options for You?

A Versatile Investment Tool

People
People Who Can Use Options. Pixabay

Options are an investment tool that can help a great many individual investors accomplish two major goals:

  • Trade/invest with less money at risk.
  • Increase the odds of making a profit.

For many years options were considered to be tools for gamblers. To a large extent, such misconceptions have been overcome -- but millions of investors still do not understand how they can benefit from using options.

So, who can use options profitably?

The very conservative investor.

The conservative investor.

The investor who wants to own a portfolio whose value does not fluctuate wildly.

The investor/trader who wants to outperform the market averages over the longer term.

The long-term investor and the short-term trader.

The aggressive trader who is willing to take high risk for the chance of earning a big reward.

Who Shouldn't use options?

But options are not suitable for:

  • The greedy person who always wants more profit and is never satisfied. When greed enters the picture, risk tends to become so large that the investor may place his whole investment account at risk. 
  • The undisciplined trader who does not understand risk management. When a trader lacks discipline, hopes and prayers (which do not produce good results) tend to become substitutes for intelligent planning. 

Options are so versatile that there are strategies suitable for almost every investor type. Options can provide excellent benefits.

However, for many strategies, the benefits of having less risk comes with limited profits. Not necessarily small profits -- but the low-risk strategies do not allow for unlimited profits.

Basic option strategies (this is merely a partial list):
 

  • Collars work for very conservative investors because they can be constructed to minimize risk. Profit potential is severely limited which is why this method is best used by the person who is most interested in preservation of capital.
  • The typical buy-and-hold (B&H) investor tends to be conservative and can adopt covered call writing as a conservative way of increasing profits over the longer term. Sure there are more-aggressive investors who buy high-risk, very volatile stocks and hold them for a while. However, most of these investors would lack the proper mindset for trading a limit-profit strategy. Read about the mindset behind writing covered calls.
  • A good strategy for the conservative BULLISH investor is to buy in-the-money call options instead of stock because if the market tanks, the loss is limited (vs. essentially unlimited losses for the stockholder). Buy only 1 call for each 100 shares that you want to own. These options should have a Delta  ~80 ± 5. NOTE: This is VERY different from buying out-of-the-money options (discussed below). 
  • By choosing a strategy that reduces the sum lost when markets decline and also limits profits when markets rally, your portfolio becomes less volatile. It is human nature to want to earn as much (or more) as other investors when the markets surge, but if you are someone who recognizes the value of avoiding large losses when the bears take control, then there are option strategies that you can adopt. These strategies have been shown to slightly outperform the buy-and-hold strategy. For example, covered call writing, the sale of cash-secured naked puts (see comment below), buying in-the-money call spreads... Note that these strategies work for both longer-term investors and shorter-term traders.
  • The aggressive trader (i.e., the gambler) often prefers to buy out-of-the-money options (calls or puts) when he/she has a prediction on which way the market is going to move. While it is true that buying these (inexpensive compared with other) options can resulting in a 10-bagger (i.e., buy an option for 50 cents and sell it for $5), most of the time the trader is far too optimistic and the options tend to expire worthless. I do not recommend this strategy, but if it appeals to you, please wait until you are a seasoned options trader who truly understands how options work.

Almost any stock market investor or trader can find something to like about options. But please be aware of just how much money is at risk at all times and avoid the high-risk strategy of selling naked puts (unless you are willing to own stock at the strike price) or naked calls.