Demystifying the World of Options

Like politics and religion, options are not a safe topic for conversation in polite company. Entrenched beliefs, misconceptions and different agendas tend to cloud the discussion. The battle lines are usually drawn along the subject of risk, both real and perceived.

As someone who writes an options column, I obviously belong to the camp that believes options are a valuable investment tool that, when properly utilized, can both boost returns and reduce risk. That said, I acknowledge the validity of many of the arguments made against options. Perhaps pointing out the most common pitfalls, rather than proselytizing on the benefits, is the best approach to bring some evenhandedness to the subject.

Operation Manual

As with any tool, before using options, make sure you are familiar with the basic rules and guidelines that govern their behavior. Although one needn’t know how to build a combustion engine to drive a car, there is a baseline of knowledge necessary to safely operate the vehicle.

Contract Specifications: Margin requirements (pay special attention to leverage), the exercise and settlement procedures, and what strikes and expirations are currently listed for trading are important to know. For example, you should be aware that index options such as for the S&P 500 (SPX:Index) can only be exercised on expiration day and are cash settled; also note that SPX options actually cease trading on the third Thursday of the month, a day earlier than equity options, though they officially expire on the third Saturday. By contrast, equity options can be exercised at any time during the life of the contract. This is especially important when trading options on stocks that pay dividends.

If you own in-the-money calls on Altria (MO:NYSE) , make sure you know when the ex-dividend date occurs — you will need to exercise your calls if you want to qualify for the payment. Likewise, if you are short an in-the-money call on a dividend-paying stock, be prepared for assignment and being short the actual shares the day before it goes ex-dividend.

Most ETFs pay dividends. Some, like the SPDRs (SPY:Amex) , pay out on a quarterly basis on the last business day of the month; others, like the Diamonds (DIA:Amex) , make monthly distributions. The point is, knowing the basic rules by which the various vehicles operate will help you avoid potentially costly surprises.

Options Pricing: While option-pricing models can be very complex and one does not need to understand all the math involved, the two components that I think are essential to have a basic understanding of are implied volatility and time decay. For example, be aware that before an earnings or news report, the implied volatility of the near-term or front-month options usually increase to a higher level than the later-dated months. If you think Google (GOOG:Nasdaq) will hit $400 in the next year, it makes no sense to buy calls that have only two weeks remaining until their expiration and only two days before the company is scheduled to report earnings. Instead, buy some LEAP options.

Pick the Right Tool: Make sure you understand the strengths, weaknesses and risks involved in each specific strategy. More importantly, make sure you then pick the strategy that best aligns with your investment thesis and will help accomplish the specific goal set for each trade or investment decision.

In a recent article, Jim Cramer, gave an example of using in-the-money calls as a replacement for buying shares of the underlying stock in what is commonly referred to as a replacement strategy, which can reduce risk and boost returns.

In an article last year, I constructed a theoretical portfolio consisting of eBay (EBAY:Nasdaq) , Broadcom (BRCM:Nasdaq ) , Yahoo! (YHOO:Nasdaq ) and Qualcomm (QCOM: Nasdaq) , comparing the costs, risks and potential rewards of owning 100 shares of each vs. one at-the-money call with six months until expiration. The cost or risk of owning the options was about a fifth of owning the shares, while the potential reward become nearly equal once the stock climbed 10% or more. One important point made in the article is that when using a replacement strategy, only buy the number of option contracts that represents the number of shares you would be willing to purchase.

On the other hand, if you are a very short-term daytrader trying to capture incremental price changes, there are very few listed options that will provide sufficient liquidity or price movement to match trading in the underlying security. For this type of trader, using options offers little advantage over trading the stock.

In all situations, you should calculate the maximum potential risk, reward and break-evens before making a trade. This will help you choose what strategy is most appropriate, keep losses to a defined amount and hopefully help you achieve superior profits.

Calculating Returns

Calculating the returns on options is one of the most confusing and difficult aspects of determining the success and/or failure of a particular trade. For this reason, it is also ripe for abuse by people who want to shed the best light on their strategy and performance.

Be consistent with how you measure returns. If you measure losses in dollar terms, don’t measure profits in percentage terms. This is important when comparing the risk/reward of buying options vs. owning stock. For example, if you own 100 shares of Yahoo! at $30 and the stock declines to $25, you lose $500, or 16%, whereas if you owned one $30 call for $2, the loss is only $200, but also 100% of your investment. Conversely, on the profit side the percentage return on the option is the more impressive number, and the one usually touted, rather than the dollar amount.

Another favorite tactic is for people to annualize the returns of short-term trades that are not repeatable over time. Don’t do this. Many option positions have holding period of just days or weeks; to annualize the returns of such a short holding period is very misleading.

Even for ongoing income strategies such as covered calls, it is very common for people to extrapolate the returns of one month, if the stock stays still, to show the annualized returns. This is nice in theory, but in reality, stocks don’t stand still and the returns can vary widely from month to month. There is no justification for annualizing the returns of time-specific, isolated trades.

The bottom line is that everyone must find their comfort zone and what works best for them. Only by understanding how options work can you determine if they have a place in your investment toolbox.