Option Tips That Help You Invest With Less Risk

Investing With Less Risk

Stock Options
Stock options for the casual investor. JPhotoStyle.com

Some people consider the use of stock options as part of a long-term investing plan as nothing short of gambling. It's really too bad that they don't really understand how options work. Options were invented as tools used to reduce risk and not primarily as tools for taking risk. For example, way back — when people did not know that the world was not flat — ship owners would buy put options on their vessels and cargo.

In effect, this is equivalent to buying an insurance policy on that boat/cargo load. Too many ships were lost, never to be seen again (at least not in their home port) and ship owners sought protection against going out of business.

A Bit of History

That's where risk takers were able to help. They sold puts on the value of the ship as it sailed out to sea. When the ship returned safely, as it did most of the time, the option expired worthless and the risk taker kept the premium as his profit. When the ship did not return by a certain date, then the shipowner exercised the put option and collected the cash value of the option — or the option's strike price.

Agreeing to a specific strike price and expiration date, as well as the premium to be paid by the ship owner to the risk taker, was accomplished via negotiation. There were exchanges (nor was there an OCC; Options Clearing Corporation) to guarantee that the risk taker would be able to fulfill his obligation to pay the ship owner — if and when a ship was lost and put option was exercised.

Today's World

Centuries later, we trade the same options — puts and calls. They are still used by risk takers and risk avoiders. There are options on stocks, bonds, commodities, real-estate transactions, etc. Most of these options are traded on a regulated options exchange, but others are bought and sold via individual negotiation.

For example, a buyer may pay $10,000 for the temporary, exclusive right to buy a specific item (such as a house, or piece of art) at a known price, for a limited time. If the transaction does not take place by the (expiration) time specified in the contract, then the option expires and is worthless. The owner of the home (or artwork) is now free to sell that item to anyone.

In 1973, options began trading on an exchange (Chicago Board Options Exchange, CBOE). Instead of buying puts and calls from strangers who advertised those options in newspapers, such as the Wall Street Journal, option traders could buy and sell their options to market makers or brokers who represented customers like themselves. They no longer had to be concerned with the financial stability of the person on the other end of the transaction. The OCC guaranteed that each option would be honored, if and when it was ever exercised. Think about how important this development was. It was now possible for option buyers to use options without being afraid that they would never get their profit. Now the options could be sold to anyone willing to buy it. And if held to expiration, the ability to exercise was guaranteed. If for some reason a customer was unable to come up with the cash required to honor the option, then that investor's broker would notify the OCC, and together they would be certain that the option owner (exerciser) is made whole.

These big changes increased the popularity of options trading. by an amount that was unimaginable in those days. CBOE volume on that first trading day (April 26, 1973) was 911 call options (puts were not listed for trading until 1977). Today, the options exchanges handle more than 4 billion contracts annually.

I've been trading options since 1977. I began by writing covered calls, a strategy that I recommend for any investor who is willing to collect a cash premium in return for accepting a limit on potential profits. Not every trader likes this strategy for the simple reason that profits are limited. However, unless you are a far above average stock picker, then hedging (reducing the risk of owning) your stocks by writing covered calls (or writing naked puts, an equivalent strategy) is one of several easy-to-understand option strategies that you can use to achieve enhanced profits.

I want to emphasize that although covered call writing does reduce risk, the risk reduction is modest and is limited to the cash collected when selling your option. Other strategies allow for far more protection against loss, but can be expensive and unsuitable for the inexperienced investor.

The bottom line is that options have been around for a long time and can be used by all investors — if they find a suitable strategy. Options can be ideal for

  • Sophisticated speculators who buy options, looking for a stock to undergo a significant price change. Be warned that too many option rookies buy the wrong options (inexpensive out-of-the-money options) and have almost no chance to make any money. 
  • Ultra-conservative investors who are most concerned with preserving their wealth can adopt the collar strategy. This very conservative strategy has a track record of significantly underperforming the market averages over the years. However, this is primarily due to the fact that stock market prices have rallied significantly over time. Yet, if you are lucky enough to have sufficient money to last your lifetime, then being conservative with that capital makes a lot of sense. If you prefer to continue earning money at a decent rate of return, then collars are not for you.
  • Average investors — that's you and me — can adopt option strategies that modify our investing landscape. The good news is that you do not have to invest a lot of money by buying stock. Nor do you have to take anywhere near as much risk as stockholders (stock prices can plummet, hurting average investors, but option investors can limit the amount of money at risk with any position).

Caveat: Do not just begin trading. Read about options and how to use them conservatively and intelligently.