I’ve heard that options are risky investments. Is that true? How do they work? — Tara, Connecticut
Options have the unfair reputation of being considered riskier than other investment vehicles. For instance, in a book written by a well-respected duo of female financial advisors who cater to divorced and widowed women, there is a table that classifies types of investments. Whereas they consider stocks to be moderate-risk investments, they include options in the high-risk category along with junk bonds, highly leveraged real estate and penny stocks. I consider this classification misleading, if not inaccurate.
Although options can be risky when used for speculative purposes (meaning that you are betting that the price of a stock will rise or fall by a specified amount within a certain amount of time), the strategies I teach in my book, “Every Woman Should Know Her Options,” use options to reduce risk when investing in the stock market. Beyond that, they do a nice job of generating income that can be spent or reinvested to enhance stock returns.
A stock option gives the holder the right, but not the obligation, to buy or sell shares of a stock at a specified price on or before a specified date. Options come in two varieties, calls and puts, and you can buy or sell either type. For example, if you buy one call option, you pay a premium for the right to buy 100 shares of stock at a designated price on or before a specified expiration date. You might do this if you think the price of a stock will go up in the short term.
If you buy a put option, you pay a premium for the right to sell 100 shares of stock at a designated price on or before a specified expiration date. You might do this if you think the price of a stock will go down in the short term.
These can be risky strategies because you can lose your entire premium if the stock fails to increase (or decrease in the case of a put) in price by a certain amount within a certain period of time. Contrast that with buying actual shares of stock where you lose your entire investment only if the company goes bankrupt. If these are the strategies that the financial advisors were referring to, then I agree with them.
Consider ‘Covered Call Writing’
However, the option strategy they clearly didn’t consider is the one I use most often and is called “covered call writing.” It is less risky than buying stock by itself, and you can even use it in your Individual Retirement Account (IRA), including a Roth IRA. A covered call consists of two steps: You buy shares of stock (or use stock you already own) and then sell call options against those shares of stock. You can use either stock or exchange-traded funds (ETFs) as the underlying security. A small percentage of financial advisors (including myself) specialize in this type of strategy, but it is also something you can learn to do on your own — with some education and coaching — in a self-directed brokerage account or IRA.
Many people I know buy a house or apartment and rent it out for supplemental income. Frankly, this idea never appealed to me because it just seemed like a lot of work. You have to find tenants, take care of maintenance issues and deal with the bank. If your goal is to generate income, then I encourage you to consider “renting out” your stock by writing covered calls. It is so much easier, faster and more convenient than dealing with real estate. You just need a computer, internet connection and some knowledge.
If you are not an experienced investor, initially you will only be granted permission by your online brokerage account to write covered calls and maybe sell put options. I think you’ll find those two option strategies more than enough to add to your investing toolbox. You have to request permission to trade options by sending in paperwork or completing a simple online form.
Here’s how covered calls work: Let’s say you bought 100 shares of Company A at $70 per share, and now the stock is trading at $74 per share. You have a $400 unrealized gain. According to the option chain (a table of dynamic option prices available on your online broker’s website), if you agreed to sell your 100 shares at $75 per share anytime between now and say three months from now by selling a call option, your account would have been credited with $245 immediately. That’s the premium you would earn for accepting the obligation to sell your shares if the buyer of the call option exercises her right.
If Company A trades at or above $75 per share at expiration, you would be obligated to sell your shares at $75 per share and keep the $245. In that case, you make a $745 realized gain ($500 plus $245). If the stock trades below $75 at expiration, you will keep your shares at whatever price they are trading as well as the $245. This is because the buyer of the call option has no reason to pay $75 for stock she can acquire in the marketplace at a lower price. In either case, the $245 is yours to keep.
Why is this strategy less risky than simply purchasing Company A at the market price? Should the price of the stock fall below your purchase price of $70, selling the call option ends up being more profitable than just holding the stock because the $245 in premium you received in income offsets some of the loss in the stock price. In fact, you could even come out profitable if the stock fell to around $38 per share.
What’s the catch? You are placing a cap on the gain you can make on appreciation of the stock in exchange for predictable and immediate income. This is the tradeoff you make when writing covered calls. However, how many times do all your stock picks go up steadily each and every month? If you are that good of a stock picker, please give me a call!
Be aware that some option strategies such as selling a call option by itself (without owning the underlying shares of stock) carry unlimited risk. I have never sold a “naked” call, and I discourage the practice. When you sell a naked call, you only profit if a stock’s share price stays below a certain price. If the stock continues to rise in price, you can end up in a lot of trouble.