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Should I Use Options?

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.

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Comments

  1. Options can be a great way to improve returns and manage risk. Unfortunately this strategy requires more time and effort than most ordinary investors have to spare.

  2. >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.

    Mike,

    I will look into this for my employee stock purchase plan shares- to get the best tax treatment I need to hold them for 2 years. Buying puts would allow me to insure against the stock price dropping in that time before I sell the stock.

    -Rick Francis

  3. Great overview of options for individuals.

    One of the practical problems with options for individuals is that it is really hard to not get killed on costs and spreads.

    I think when you think about trying to limit downside or otherwise reduce risk using options, you have to keep in mind that you’re buying insurance. As with all insurance you have to keep two things in mind.
    1. Insurance costs you money on average.
    2. Because of 1, you buy insurance to protect yourself only against the risks you can’t afford.

  4. Correct me if Iam mistaken, but If Iam an average investor investing in non -retirement account for the long term (lets say at least 5 years) would the costs be not justified for the puts? After all if Iam investing in index funds and vested in them for the long term why would I spend more money on puts ?
    btw, thanks for the article that explains them in clarity.

  5. Jay,

    Even if you’re not bothered by declines (because you assume the price of the investment in question will rise again), puts could still improve return in some situations.

    For example, let’s say you buy $100,000 of an ETF and you intend to hold it for 30 years, so you could care less above movements between now and 30 years from now.

    And let’s say you buy sufficient puts to allow you to sell all those shares for $95,000 any time in the next month.

    Now, let’s imagine that in the middle of the month, your ETF declines, such that your holdings are now worth $90,000.

    You could exercise the puts and sell your holding for $95,000. But because you don’t care about temporary declines and you’re just as happy to hold the ETF at its current price, you use that cash to re-buy $95,000 of the ETF — with the end result being that you now have $5,000 more of the ETF than you would have had without the put.

    So, whether or not you care about declines, there are some scenarios in which puts would improve returns.

    So the question is, would continually purchasing puts be expected to provide a better return than using that money to buy a little bit more of the ETF every period? I’ve yet to come across any evidence indicating that the answer to that question is “yes.”

    Hence the conclusion I presented above that options aren’t all that useful for most investors. They’re really only beneficial when something is getting in the way of a simpler solution.

  6. Thanks a lot for the detail

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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