Mark D. Wolfinger
Do the words “stock options” make you uneasy? Without quite knowing why, do you have the feeling that stock options are dangerous and should only be used by speculators? You have plenty of company. Many people are under the same misconception.
Do you drive a car? Would you consider getting behind the wheel if you didn’t know the difference between the brake and the accelerator? Would you drive without understanding the traffic laws or being able to read and understand road signs? Of course you wouldn’t. If you don’t have a basic understanding of the basics of driving, it would be a dangerous thing to do. But, you do drive, knowing the risks. Because you have taken the time to learn to drive, you feel confident in your ability to handle all situations. To you, driving is not dangerous.
Options can be looked at in the same way. Anyone who takes the time to understand the basic principles of options and how they work learns that options are not dangerous, and, in fact, can be used to reduce the risk of investing in the stock market. Rather than being tools used by speculators, they can be conservative, risk-reducing tools used by prudent investors.
You took the time to learn to drive a car because you knew, in advance, of the benefits to be gained from being able to provide transportation for yourself and your family. Many more people would learn to use options, if they understood the potential benefits. It’s true that options can be used in high risk strategies, but, it’s also true that cars can be used for drag racing. Just as automobiles provide safe transportation for drivers who are careful, so too can stock options be used to reduce your chances of losing money from your investments.
How options work
Do you buy auto insurance for your car every year? Are you glad you have a guarantee that you won’t suffer a large financial loss if that car is destroyed in an accident? Did you know the automobile insurance policy is very similar to buying a put option on your automobile? Have you ever had the insurance company issue a check to replace your car – either because it was stolen or destroyed? If you did, you were simply exercising your rights as the owner of a put option to sell your insured item at a specified price. The insurance company, as the seller of the put option, was obligated to buy your car. That’s not a complicated process, is it? A stock option works in exactly the same way.
When you go to the supermarket to purchase an item on sale, has the store ever run out of that item? Did you accept a raincheck from the customer service department? Did it make you uncomfortable to use that raincheck? Would it surprise you to know the raincheck is really a call option? Options have played a role in your everyday experiences for years. They are much more common than most people realize and are simple to understand. Does anyone have to explain how to use that raincheck? No. It’s a simple concept. The raincheck allows you to return to the store before a specified date to purchase the sale item at the sale price. You have no obligation to use the raincheck and may toss it into the trash. Stock options work the same way.
When you ride the subway, bus, or other form of public transportation, have you ever bought a transfer? Wasn’t it easy to use the transfer? That transfer is a call option because it entitles you to obtain a specified item (another ride) at a specified price (free) within a specified period of time (before the transfer expires). The transfer is very uncomplicated. It’s your choice. If you want to do so, you exercise your option to accept the free ride, but you are under no obligation. Even though you paid for the transfer, it’s your right to discard it and allow it to expire unused. Stock options work the same way.
Let’s look at the formal definition of an option:
A call option is a contract that gives its owner the right, but not the obligation, to buy a specified item (100 shares of a specific stock) at a specified price (strike price) through a specified expiration date (3rd Friday of the specified month).
Example IBM Apr 120 call
An option granting its owner the right to buy 100 share of IBM @ $120 per share, any time through the 3rd Friday of April
A put option is a contract that gives its owner the right, but not the obligation, to sell a specified item at a specified price through a specified expiration date.
Example MSFT Oct 25 put
An option granting its owner the right to sell 100 shares of Microsoft @ $25 per share, any time through the 3rd Friday of October
Options are versatile investment tools and can be used in a variety of strategies. Some strategies are very conservative and are appropriate for any prudent investor. They may even be used in retirement accounts. Some strategies are wildly speculative and should only be used by gamblers. Sadly, those who gamble (and lose) with options are the ones who receive publicity. That’s why you may feel, without really knowing why, that options are dangerous or are strictly for speculators.
You don’t hear about investors who quietly reap the benefits of a conservative and successful options strategy. The newsmakers cover the story of the rogue trader who inappropriately abuses his responsibilities and loses huge sums for his employers in the options or futures markets. The conservative family whose IRA account grows at 15% – year after year – is unnoticed by the world. You have that uncomfortable feeling about options due to unbalanced media coverage. Who can blame the journalists? They cover the stories that interest their customers.
If you invest in the stock market, if you want to own stocks or mutual funds, then you owe it to yourself to learn about stock options and how they can be used to reduce the risk – let’s repeat that – to reduce the risk of owning those investments. In addition, when you use the recommended options strategies, your chances of earning a profit are increased. Less risk, more frequent profits. That’s an excellent combination of attributes for anyone’s investment portfolio. No guarantees of success are offered. When you own stocks or mutual funds, they don’t come with guarantees either.
Ask your broker or financial advisor about adopting conservative option strategies. If your broker is not knowledgeable about options, find another who is. Even better, learn about options for yourself. There are books and online sources available to you. I recommend The Rookie’s Guide to Options (which I wrote).
As with any investment in the stock market, there is no guarantee against loss, but learning to adopt one of the lower risk option strategies may make it much easier for you to achieve your financial objectives.
Mark Wolfinger has been a professional options trader since 1977, primarily as a CBOE market-maker. For the past eight years he has been an instructor of individual investors, helping them use conservative strategies to reduce risk and enhance profits. His most recent book, The Rookie’s Guide to Options: The Beginner’s Handbook of Trading Equity Options describes (in detail) how to use six conservative strategies. Send e-mail to email@example.com.