Options Investing – Does it Deserve a Place in Your Personal Portfolio?

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company stock, derivative securities, ETFs, individual stocks, individual stocks vs. mutual funds, mutual funds, options, options investing

Out of the numerous investing and personal finance topics we have discussed so far on this site, one topic that has not yet been addressed in any kind of detail is investing in options contracts.


Why has this topic not yet been covered? The answer is pretty easy – because I don’t personally invest in options since I employ a passively managed approach to investing using ETFs and index mutual funds, and do not trust myself to correctly make predictions on price movements of stocks/ETFs/indices.

However, just because I personally do not use options does not mean that learning about this type of derivative investment lacks value. In fact, I believe that it is important to have a sufficient understanding of all investment options available so that you can know how and why markets respond the way they do, and you can then act in a rational manner.

What is Options Investing?

For some reason or another, in receiving my finance undergraduate degree, the professors seemed to REALLY enjoy going in to a lot of depth about options investing strategies. Looking back on it, I hypothesize that probably most of the detail was taught from the perspective that we would potentially use it if we got full time jobs working at investing firms. I’ve since learned that from a personal finance perspective, there is no need to go in to SO much detail to understand what options investing is, and a basic understanding can get you a long ways. So, let’s start there, shall we?

Essentially, an option is a derivative financial instrument (derives its value from the underlying security the option pertains to) in the form of a contract between the buyer of the option and the seller of the option based on price movements of the underlying security.

  • The options buyer pays an upfront price (called the premium) for the right (not the obligation – hence the name, “option”) to execute a future transaction at a specified price (called the strike price) before a specified expiration date.
  • There are two basic types of options – call options and put options
    • Call options give the contract buyer the right to purchase shares of a security (security means that options are not limited to only individual stocks) at the strike price.
      • This generally makes the buyer money if the price of the security increases.
    • Put options give the contract buyer the right to sell shares of a security at the strike price.
      • This generally makes the buyer money if the price of the security decreases.

Let’s just go through a quick example to help illustrate how this process works:

Currently, the price of a call option for the Gold ETF (ticker symbol – IAU), expiration Feb 18 2012, $14 per share strike price is $2.90 per share. The ETF is currently trading at $16.82 per share.

Since you think the price of the Gold ETF is going to increase, you buy this call option for 10 shares, paying 10*$2.90 = $29.00 for the contract in the form of a premium. If, by February 18th, the price per share has increased to $20, you would exercise your option to buy 10 shares at $14 (the strike price) and then automatically sell them at $20 per share for a final profit of $31.00. (10 shares * ($20-$14) = $60 – $29 premium for contract).

On the other hand, if you were wrong about the price movement, and the price actually decreased, you would not exercise the option at all and only lose your $29 premium to the options seller. Make sense?

What Uses Can Options Investing Have in Your Portfolio?

In my mind, options investing can play one of two roles for investors:

  • Making money – 
    • This one is fairly obvious. Since options do not require you to actually have the money to buy the underlying securities, you can potentially make a lot of money if you are good at predicting price movements without much capital cost.
  • Hedging risks for your other investments/operations – 
    • Perhaps a more applicable and fascinating potential use of options to me is that options can be used as a hedge for risk in a person’s investments or business’ other operations.
    • For example, if you run a business operating abroad and have a significant asset stake tied up in the faith that another country’s currency stays strong, you can use a put option to make some money in the event that the currency in the other country gets devalued.
    • Also, a put option could be used to provide some upside potential in the event that huge losses are realized in the long positions in your retirement savings.
    • The put option mentioned here is probably the most basic type of hedge you can create using options. For some additional reading on more complex strategies that are available (covered calls, straddles, butterflies, etc), I recommend the following resources:

How/Where Can You Invest in Options?

If it sounds like options are something you want to try your hand at in your personal portfolio/investing strategy, I’d recommend that you start off with only a small amount of “play” money until you gain more experience and comfort with the process.

When it comes time to actually sit down at the computer and start investing in options, it’s fairly easy to find a brokerage in which to open an options trading account. This is because most, if not all, of the major discount brokerages online now offer options trading accounts.

Whenever you make your final selection of the brokerage that you want to house your options account, be sure to remember to search around the Internet for any promotional account sign up offers that are often available. For example, by using an Optionsxpress promo code, you can receive $100 when you open a new account, fund it with at least $500, and make 3 trades within the first year. A pretty nice deal!

How about you all? Do you currently or have you in the past invested in options as part of your investing strategy? Why or why not? 


If so, how did it work out for you? Did you lose or make money?  


Share your experiences by commenting below!

***Photo courtesy of http://farm4.static.flickr.com/3231/2944592688_3f3de8a417.jpg

Comments

  1. Options can definitely make you money and the downside is limited by the premium. If you already own shares you can also make extra money off those shares by selling covered calls. In this case if the option is exercised you do have to sell your shares, but if it is at a suitable profit that could be ok. In addition you get the premium when selling the call which increases your profit. And if the calls never reach the strike price you get to keep both the shares and the premium. Personally though I will be sticking with index mutual funds and ETF's along with solid dividend bearing stocks. Options are an interesting topic though.
    My recent post My Secret to Get Rich Quick (Enough)

    • Well said Money Infant. I am very fascinated by the use of options to potentially hedge your equity positions.
      My recent post Sensible Spending and Saving For You And Your Family

  2. I made and lost some pretty big sums in option trading, so much that I got a little gun shy. I realized I don't really have the risk tolerance even though the rewards can be pretty hefty if you're smart and lucky.
    My recent post The First Step In Organizing Your Tax Information

  3. I prefer index investing, myself. KISS. 😉
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  4. Dividend Monk says:

    I don't buy options, but I do sell them.

    My recent post 3M Company (MMM): Focusing on the Right Areas

  5. I have been interested in options for sometime, and would actually like to start trading to generate some side income while I'm still in college. This post was a good read for a beginner like me that has never touched the options game. Gotta learn the basics before touching the advanced strategies.
    My recent post Finding the best Credit Card for YOU!

  6. I've always thought that options were just too much complexity for the average investor. I don't do it in part because of the complexity but also because I don't have the patience to really delve into it. I can get so much more (for less time and commitment) out of index funds.
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  7. I am a very cautions options trader and have been for years. For the most part, i use options as a way to enter and exit stock positions, either selling puts to buy stocks I intend to buy anyway, and writing covered calls to exit a position. Less frequently I will use options to hedge against wild swings in a stock I own if there is some pending event I know about. Rarely I will trade options on their own. And this is ONLY in my fun-trading account – I am far more conservative with retirement and long term investments.
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  8. Busy Executive says:

    I've always struggled with the time decay component of options. Have largely left them alone as my tendency to buy and hold just wins out in the end. I marvel at those able to do it successfully however.
    My recent post My valuable credit card lesson

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