Joseph writes in to ask,
“I recently read about using stock options to reduce the amount I lose when stocks fall. It sounded like a good idea, but I’ve read elsewhere that options are very risky. Who’s telling the truth? And should I be using options?”
Before answering Joseph’s questions, let’s take a step back and briefly cover the very basics.
How Do Options Work?
There are two basic types of options: calls and puts.
A call is a contract that gives you the right to buy something at a specific price (the strike price) any time between now and a specific point in the future. For example, you could buy a call that would allow you to buy 100 shares of Apple at $400 per share any time in the next 30 days.
A put is a contract that gives you the right to sell something at a specific price any time between now and a specific point in the future. For example, you could buy a put that would allow you to sell 100 shares of Apple at $350 per share any time in the next 30 days.
To buy a put or a call contract, you pay a price known as a premium. The more of a long-shot the option is, the lower the premium will be. (For example, buying a call with a strike price $10 above the stock’s current market price will cost less than a call with a strike price $5 above the stock’s current market price.)
Alternatively, rather than being the one to buy either of those options, you could be the one to sell them. That is, in exchange for receiving the premium (the price of the option) you’d be giving somebody else the right to buy shares from you (in the case of a call) or sell shares to you (in the case of a put) at a specific price any time before the option expires.
In addition, you can combine calls and puts (and the buying and selling of each) in various ways to create specific bets — a bet that a given stock will either fall by more than 10% or go up by more than 10%, for example.
Are Options Risky?
Options are not inherently risky. Rather, the riskiness depends entirely on what type of option strategy we’re talking about.
For example, if you buy a call option with a strike price that’s far above the stock’s current market price, the most likely outcome is that the option expires without ever being exercised. In other words, the most likely outcome is that you lose all the money you spend on the option.
Alternatively, options can be used to reduce risk. For example, if you owned shares of Vanguard Total Stock Market ETF, you could buy a put for that ETF that would effectively limit your maximum loss in the event of a market downturn.
Should I Be Using Options?
While options can achieve helpful outcomes, there’s usually an easier way to do it.
For example, if you want to reduce the risk in your portfolio, it’s easier to just modify your asset allocation to include more cash and/or bonds rather than continually purchase put options for each of your holdings. (Remember, options expire, so you’d have to purchase new ones regularly in order to maintain the protection you want.)
There are some circumstances in which options play a role that nothing else really can. For instance, if a high portion of your net worth is in a given stock that, for one reason or another, you’re not allowed to sell, you may be able to reduce that risk by buying puts on that stock (if you’re allowed to) or on a security that’s likely to move in a similar direction to that stock.
In other words, options are not inherently risky. Nor are they inherently bad. They have their uses. It just so happens that for most individual investors, those uses are few and far between.