Should You Use Options? Definitely, Just Practice Safe Strategy

by: SA Editor Rocco Pendola

Somehow, a portion of the comments section in a recent article about Apple's (NASDAQ:AAPL) dominance turned into a mini-debate over the safety, or perceived lack thereof, of options trading among retail investors:

After my initial response and disagreement with these comments, both readers, interestingly, made note of their credentials, which apparently include "fund manager," "equity analyst" and "investment bank" consultant to "hedge funds and corporations on equity option strategies."

Shortly after my retort to one of the commenter's responses, he backed off with the following reply:

Nevertheless, the arguments these two individuals made do not come from left field. In fact, large numbers of investors share the same or similar sentiment.

In this article, I attempt to ease the concerns many retail investors share over working options into their portfolio strategies. I start by posting part of the comment that caused "bailinnumberguy," who told me I only advocate using options because I "have a book to sell," to backtrack:

I only use a somewhat "racy analogy" because I think it's apropos to the debate and my points. Plus, we're all adults here. But, in complete seriousness, consider the reasons why the teenage and young adult pregnancy rates continue to trend lower in the United States.

Now let me be clear, I agree with the commenters who urge caution with relation to options. By the same token, I agree with those who urge teens and young adults to exercise extreme caution and even abstinence. I part ways with people, however, who preach caution in either case, but also advise a closed approach. As in, don't even bother learning about the subject and, in turn, do not arm yourself with the information and the tools you need to keep yourself healthy and safe.

For years, lack of information has either kept retail investors away from options or put them in a position to use inappropriate strategies and methods if they did jump in. Unfortunately, the good work entities like the Chicago Board Options Exchange (CBOE) and the Options Industry Council have done in recent years educating investors about options has brought not only good, but some bad.

While more retail investors use options for the right reasons - meaning they use strategies that present relatively less risk than other more advanced routes - weekly option use among retailers accounts for a considerable portion of recent record option volumes. That's not a good thing. Because of the incredibly short time to expiration and other incredibly complicated factors, unless you're writing conservative covered calls against a position you're OK giving up, you're likely to get burnt unless you really know what you're doing.

By a similar token, most retail investors - and probably quite a few prop and institutional folks - should never even entertain using intermediate to advanced options strategies, trading deep out-of-the-money contracts, trading contracts with near-term expirations and day or swing trading any type of option contract, long or short.

That said, sticking your head in the sand and ignoring options altogether because they can be risky or working to keep others from options information is as dangerous as sending your kid out into the real world completely uninformed and wet behind the ears. If you're going to go ahead and use options, despite warnings not to, you're best to embark on a game-plan that suits the limited knowledge of the product most retail investors have or can hope to gain. And this pretty obvious advice does not apply only to options, it applies to stocks, bonds, currency, cattle futures, playing poker and any other similar venture.

I did not write a basic options strategy eBook to game people out of nine bucks. Believe me, the sales volume I'll see will hardly make me rich. I wrote it because there's an incredible demand for the most basic options concepts and strategies even green investors can safely and effectively work into their portfolios today. Practically everything that's out there works in terminology and trade types that will do nothing to help everyday investors, but only confuse and potentially harm them.

While the CBOE provides excellent information, some of the marketing it does probably does not or at least should not target retail-level investors. If you watch Blackhawks hockey, you'll see a CBOE ad on the boards at United Center. That's great, except the ad promotes the S&P 500 Volatility Index (^VIX) options, hardly a product most hockey fans should start toying with.

Investors can benefit from options if they use them less like trading vehicles and more like investments that attempt to replicate direct stock ownership as best as possible, "short" a stock via puts, mitigate risk and generate income.

To do this, most investors should never venture beyond using:

  • Long calls that come as close as possible to simulating ownership in the options underlying stock. This means stay away from out-of-the-money contracts with near-term expirations. LEAPS options work best for long-term investors looking to take part in stock movement for a fraction of the cost of buying 100-share lots of a stock outright.
  • Long puts that are not too far out-of-the-money and/or to close to expiration. I agree that shorting stocks is a relatively dangerous proposition for most investors. I do not do it, nor do I advocate it. This is not because I am philosophically opposed to it - I think shorts are good for the market - rather, I don't like the margin disasters shorting can create. Played properly, long puts considerably cut the risk of betting a stock will go down.
  • Covered calls serve to mitigate risk and generate income from long stock positions. They're, almost unarguably, the safest and most effective options strategy for investors at all levels.
  • Cash-secured, not naked, put writing, used cautiously and sparingly, can generate income and achieve the goal of getting long an underlying stock.

Remember, these are just bullet points and the following examples are merely general illustrations of how most investors can employ several elementary strategies.

You own 100 shares of Cisco Systems (NASDAQ:CSCO). You bought them for $15.00 apiece. You want to generate more income from your shares. You write a February $20 call and receive roughly $34 for selling the premium.

You believe in Cisco's long-term future. You want more exposure to the stock, but you're not prepared to buy a considerable number of shares. You purchase a CSCO January 2014 $20 call (a LEAPS option). One call sets you back about $291, a fraction of the capital it takes to purchase 100 shares of the contract's underlying stock.

Let's assume you think Microsoft (NASDAQ:MSFT) has no future. You could short the stock, which has been on a roll, and expose yourself to margin requirements. Depending on your account equity situation, any sizable short sale is going to require a considerable amount of margin buying power. If you cut things too close and MSFT continues to run, you could get hit with the dreaded margin call.

You can eliminate that portion of the risk of exercising your downside conviction by purchasing MSFT October $28 puts for about $256 each. That's about one-tenth the value of 100 MSFT shares and the position requires a margin account, but not the actual use of margin to execute. Set a reasonable stop loss and you have no more risk, actually less, than following your sentiment via stock.

The only time I've ever gotten into trouble with options is when I tried to get too cute and went in over my head. But, come to think of it, those circumstances also explain most of the times I got into trouble with stocks or girls, for that matter.

Endpoint - when used in relatively conservative fashion, options present no more risk than stocks or any other type of speculative endeavor that involves money, inherent risk, hard work, time and conviction.

Disclosure: I am long AAPL.

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