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Options and the conservative investor: Proceed with caution

Are options a type of security that conservative investors should consider out of their league? It depends on how they’re used — keeping in mind that they’re typically used for speculation.

An option is a contract that grants the buyer the right to transact a specified asset at a fixed price before a specified date.

The buyer can choose to exercise the option at any time during the specified period, or allow the option to lapse. He can also sell the option during the time period at the prevailing price.

Options on stock come in two forms, “calls” and “puts.” A call is the option to purchase a specific number of shares at a specified price for a specific time frame (generally for 30, 60 or 90 days). A put is the right to sell a specific number of shares at a specific price for a specified time frame.

If you believe that a stock is going to increase in price in the short term, you might buy calls. If you believe the share prices will fall, you might buy puts.

Why buy call options instead of actual shares in the first scenario? Options increase your leverage, which increases your return. The downside is that if the stock does not increase in value, and the option expires, you lose 100 percent of your investment.

Suppose you like a stock that sells for $18. You think that during the next 90 days the price will be close to $25. You purchase five, 90-day call options (100 shares per option) of the stock at $20 (known as the strike price) for $1/share. The cost to you is $500 plus commission (for example, $20). If the stock does poorly, and never increases in price, there is no reason to execute the option at the end of 90 days, in which case you have lost $520.

On the other hand, if the stock does increase, you can execute the option during the 90-day period, or sell it any time during that period. Until expiration, there will be an active market for your option. Assume that near the end of 90 days, the stock price is $23, and therefore the options are worth $300. You sell all five options for $1,500, less commission, for a net profit of $960, a return of 192 percent. (Note that if you want the stock, you can exercise the option.)

If you had purchased the common stock outright, the profit at the end of 90 days would have been approximately 28 percent (a gain of $5 on an investment of $18). However, if the stock stayed at $18, you would have no loss, while you would have lost 100 percent of your option purchase.

So buying calls is riskier than buying stock but pays much more when the investor’s bet is correct. (Puts work much the same way, but in reverse.)

So what business would a conservative investor have in dealing with options? Here’s an example: Suppose you own common stock, and you do not want to sell but are concerned about a possible drop in price. You could protect your position by buying puts.

And then there is a trade known as a “covered call.”

Assume you purchased a common stock 9 months ago at $20, and now it’s selling for $28. If you sell it today, you would have a profit of $8 per share. However, since you haven’t held it for a year, you would owe ordinary income taxes on the gain. You are unsure whether the price will go up further. You tell your broker you are willing to sell your stock for 90 days at $30/share. You are effectively selling a call. The amount you receive will be based on the perceived volatility of the stock (assume $1.50 per share). If the stock goes above $30, the option will be executed, and you will no longer have the stock. If the option is not executed, you keep any dividend declared during the 90-day period in addition to the amount you received for selling the call, and you could then sell another call.

Although some conservative investors utilize these, covered calls are not that conservative. The downside is that you still retain the risk of any drop in price, and you lose the opportunity of any significant increase in price.

To learn more about stock options, read Trading Options for Dummies (Wiley, 2008) by George Fontanills.

Elliot Raphaelson welcomes your questions and comments at elliotraph@gmail.com.



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