Options: The Profit Strategy Behind This Oft-Overlooked Investment Tool

Stock options are a valuable tool for any investor who wants to increase income, maximize returns, and better control risks in his or her stock portfolio.

Yet despite these benefits, few investors make an effort to use - or even understand - options strategies.

If you're among this group of reluctant option traders, it's probably because you're a victim of what I call "The Options Myth," which goes something like this:

"Options aren't for you. Only really sophisticated and experienced investors should consider options. With options, it's all or nothing; you can lose your entire investment. At least with a good stock you know it's not going to zero. If you're wrong, you've always got a chance for a comeback, because you still own something!"

This mantra is chanted to clients by thousands of financial professionals around the world - "advisors" who either don't understand options themselves or view them exclusively as ultra-high-risk. Some mainstream brokerage firms - Edward Jones, for example - refuse to let their account holders trade them.

But the truth is, options can be for you - and they should be, whether you're a go-for-the-gold speculator, an average investor looking to hedge your portfolio against market pullbacks, or a retiree seeking a little extra cash flow from your dividend-paying shares.

Here's a quick primer on the options basics - all the information you need to fully understand what they are, how they work, and why they should be part of your investing arsenal.

First, a little background...

The Growth of the Options Industry

Although the concept has been around for centuries, options as we know them today are barely four decades old.

Initially, options were individual contracts negotiated on a one-to-one basis between buyer and seller. Prices and terms varied substantially, and the underlying assets involved ranged from stocks and real estate to farm crops, metals, and even tulip bulbs.

That changed on April 26, 1973, when the Chicago Board Options Exchange (CBOE) first made "listed" stock options available. "Listing" on a recognized exchange meant that all key aspects of a stock option contract were well defined, with standardized expiration dates and strike prices.

More importantly, it meant a ready market for trading options, with a clearing corporation set up to protect the interests of both the buyer and seller.

Any CBOE member broker anywhere in the country could now take your option order and submit it to the exchange, and it would be matched up with an opposite order from somewhere else - no face-to-face contact needed. Commissions, though quite high by today's online standards, also became reasonable, compared to earlier days when so-called "put and call brokers" had to negotiate every aspect of an option trade.

Listed options turned out to be a huge success. Annual volume mushroomed from under two million contracts in 1973 to nearly 100 million in 1980.

Today, the Options Industry Council (OIC) estimates nearly 300 million options trade every day, with more than 3.6 billion contracts having changed hands last year. Options trade on nearly 40 exchanges worldwide, with more than a dozen electronic trading venues - eight in the U.S. alone.

Of course, those numbers are pretty meaningless if you don't really know what an option is or how it works, so let's get back to the basics.

Understanding Stock Options

For starters, an option is defined as a type of derivative contract that gives its holder the right, but not the obligation, to buy or sell an underlying financial asset at a specified price during a set period of time or on a specific date.

(NOTE: Most standardized options are so-called "American" options, meaning they can be exercised at any time prior to the expiration date. But there are also "European" options, which can be exercised only on the expiration date.)

The underlying assets that have "listed" options include more than 2,600 individual stocks (in 100-share lots), exchange-traded funds (ETFs), broad market indexes and specific market sectors (these are usually what are known as "cash-settled" options), currencies, interest-rate instruments, commodity and financial futures, and even some physical commodities like precious metals.

Regardless of the asset underlying an option, however, there are just two basic types:

  • A CALL option gives its owner the right (but, again, not the obligation) to BUY a specific underlying asset at a designated price for a limited period of time. For example, a January 30 WFC call option would give its purchaser the right to buy 100 shares of Wells Fargo & Co. (NYSE:WFC) common stock (the underlying asset) at a price of $30 per share (the strike price) at any time between the date of purchase and the option's stated expiration date (in this case, January 21, 2011), no matter where WFC's trading at that time. (The "30" refers to the price, $30, and is not part of the January date. I'll explain in a moment why it expires January 21.)
  • A PUT option gives its owner the right to SELL a specific underlying asset at a designated price for a limited period of time. For example, a February 15 DELL put option would give its holder the right to sell 100 shares of Dell Inc. (NasdaqGS:DELL) common stock at a price of $15 per share at any time between the date of purchase and the option's stated expiration date (in this case, February 19, 2011).
  • Both puts and calls have three general identifying features:

  • The underlying asset: As a derivative, an option must first be identified by the asset from which it derives its value - e.g., in the first instance above, 100 shares of Wells Fargo common stock.
  • The "strike" price: Also called the "exercise" price or the "striking" price, this is the price at which the option can be exercised. In other words, it is the price at which a call holder has the right to buy the underlying asset or a put owner has the right to sell it. In the second example above, the strike price is $15 per share, meaning the put holder can sell 100 shares of Dell stock at that price any time prior to February 19, 2011. The intervals between strike prices vary from $1.00 for lower-priced and some actively traded mid-range stocks, to $2.50 for moderately traded issues, and $5.00 for higher-priced shares.
  • The expiration date: This is the date after which an option can no longer be exercised to buy or sell the underlying asset (and thus ceases to exist). In the United States, listed stock options normally stop trading on the third Friday of the expiration month (and officially expire the following day). Listed options trade on primary cycles with expiration occurring every three months - e.g., Cycle 1 options expire on the third Friday in January, April, July, and October. However, the most popular stocks also have shorter-term "serial" options that expire on the third Friday of the intervening months. A few very heavily traded stocks even have options that expire weekly.
  • (NOTE: Check out the "option chains" for WFC, DELL, and many other stocks on Google Finance or Yahoo! Finance to get a better idea of the range of strike prices and expiration dates for current listed stock options. Yahoo also has a special section in its "Options Center" that can help you learn to read option symbols - they tend to look, at first glance, like a random string of numbers and letters.)

Stock Option Appraisal

The final element in understanding options is how their prices - or "premiums" - are determined, as well as some of the factors that cause those premiums to change over the life of the option.

To begin with, option premiums are made up of two parts - "intrinsic value" (or "real value") and "time value."

All options have time value. But only "in-the-money" options have intrinsic value - which is the actual difference between the option's exercise price and the current market price of the stock. Thus, call options have intrinsic value only when the current stock price is above the option's exercise price, and put options have intrinsic value only when the current stock price is below the option strike price.

For example, if Wells Fargo stock was priced at $30.75, and the January 30 call listed above had a premium of $2.45, then the call would have an intrinsic value of 75 cents ($30.75 stock price - $30.00 call strike price = $0.75). The rest of its premium - $1.70 ($2.45 - $0.75 = $1.70) - represents time value. On the other hand, if Wells Fargo stock was priced at $29.05 and the January 30 call had a price of $1.35, then the entire option premium would be time value.

In the first instance, the buyer of a January 30 WFC call would need the price of Wells Fargo stock to rise to $32.45 (the strike price plus the premium paid for the call) on the expiration date to break even. At any level above that, he or she would profit. At any Wells Fargo price between $30.00 and $32.45, the call buyer would suffer a partial loss of the $245 ($2.45 premium x 100 shares) he paid for the option. At any WFC price below the call's $30.00 striking price, he would suffer a total loss. However, $245 would be the most he could lose, regardless of how far Wells Fargo stock fell below $30.00.

In the real-life case presented second, the buyer of the January 30 WFC call would need the price of the stock to climb above $31.35 to make a profit, would suffer a partial loss at a stock price between $30.00 and $31.35, and would lose the entire $135 he paid at any WFC price below $30.00 a share.

In the case of the put option, if DELL stock was priced at $13.75 and the February 15 put had a premium of $2.90 - meaning it was in the money (ITM) - then the put would have an intrinsic value of $1.25 ($15.00 put strike price - $13.75 stock price = $1.25). The rest of its premium - $1.65 ($2.90 - $1.25 = $1.65) - would be time value. By contrast, if Dell's stock was priced at $15.30 - meaning the put was out of the money (OTM) - and it had a price of $1.55, then the entire option premium would be time value.

The buyer of the put in the ITM scenario would need the price of Dell stock to fall to $12.10 to break even ($15.00 - $2.90 = $12.10). He would suffer a partial loss at any price between $15.00 and $12.10. And he would suffer a total loss at any price above $15.00, but would profit at any Dell price below $12.10. In the OTM case, Dell would have to fall to $13.45 for the put buyer to break even, but he would profit at any lower price, though he'd suffer a total loss at any level above the put's $15.00 strike price.

The intrinsic value of an option is absolute. It always represents the difference between an in-the-money option's strike price and the actual stock price.

By contrast, time value changes constantly. It's based on an assortment of factors, ranging from the volatility of the underlying security and the market as a whole to the degree by which the option is in or out of the money and - most importantly - the amount of time remaining until expiration.

As a rule, the basic equation in option pricing is "the more time, the more time value." As such, options are considered to be "wasting assets," meaning their value (and price) drops as they approach expiration.

It is this erosion of time value that motivates most sellers of stock options. They hope the options they sell will wind up out-of-the-money (OTM) on the exercise date and thus expire worthless, allowing them to keep the entire premium they received for selling the option (or part of it, if the option is only slightly ITM).

Outright buyers of stock options are, of course, hoping for the opposite result - a move in the price of the underlying stock by expiration sufficient to cover the premium they paid for the option and give them a nice profit, to boot.

Their primary motivations in buying options are the absolutely limited risk of such trades and the high degree of leverage they provide.

For example, in the Wells Fargo trade, the call buyer controlled $2,905 worth of stock for more than two months at a cost of just $135. That was also his maximum risk of loss. Yet his profit was theoretically unlimited - and his potential return was truly phenomenal.

To illustrate, if WFC's stock price climbed to $36.00 a share, the option buyer made a profit of $465 on the trade, giving him a return of 344.4% ($465/$135 = 344.4%). If WFC stayed below $30.00 a share, he lost just $135. A stock buyer, on the other hand, had $2,905 at risk. So she would have made $695 on a rise in the price to $36.00 a share, but her return would have been just 23.9% ($695/$2,905 = 23.9%). And her loss could have been as much as $2,905, had Wells Fargo stock plunged to zero.

The advantages to the option buyer are clear, but with time-value erosion always working against him, the outright purchase of options can only be considered a stark speculation.

However, as mentioned at the beginning, there are a couple of dozen other option strategies that have substantial added benefits and far more acceptable risk/reward scenarios.

So watch for future Money Morning strategy pieces on how to make options an integral part of your investment program.