Explore your options

Explore your options
Despite their risky reputation, options aren’t just for aggressive investors

An option is the right to buy or sell a particular security at a set price within a specific period of time. Options trade on exchanges throughout North America. Each has a listing and ticker symbol, much like a stock. Options trade on a variety of underlying securities, but we’re going to restrict this article to listed equity options.

Types of options
There are two types of options: calls, which give the buyer the right to purchase a stock at a specified price for a predetermined period of time; and puts, which give the buyer the right to sell a stock at a specified price for a predetermined period of time.

We haven’t heard much from the world of options and other derivatives in the financial press lately. With the so-called “New Economy” on the rise, technology and the Internet have taken centre stage for many investors. Or maybe the investment world has finally reconciled itself to these instruments that, historically, have been best known for their connection to financial disaster.

Whatever the reason for the cent lack of attention, it’s really too bad that options are ignored by many individual investors. Used properly, options are important tools and, in a well-conceived financial plan, they can be used to avoid risk and enhance returns.

Should you use options in your portfolio?
It depends on your investment goals. Above all, it’s important to keep your eye on the big picture and figure out how an option strategy fits into your overall portfolio. First, you should establish some goals and determine whether the underlying stock suits your objectives. Next, consider whether using an option strategy or simply buying or selling the stock itself will best fulfil these goals. If you do decide to use options — and they can be used effectively in many situations – ensure you understand all the implications of your strategy, including getting expert advice when you need it.

Following are some examples of how options can be used to reduce portfolio risk:

Put options can establish a purchase price
For example, I recently decided I’d like to own 100 shares of Nortel Networks, on my advisor’s recommendation.

At $53 a share, we felt the stock price could go lower still. One of our choices was to hold off purchasing until the stock declined to a level that was acceptable to us, keeping the funds placed in a T-Bill in the meantime.

But there’s an alternative strategy involving options that would allow me to purchase at a price I was willing to pay and, at the same time, providing me with some revenue if the stock never reached my target price. In other words, I could profit even if the stock did nothing.

Here’s how my Nortel strategy worked: I sold a put option with an exercise price of $50 and an expiry date of the third week of January at a price of $4.30. This meant that someone else (the purchaser) was buying the right to sell the stock at $50 until January. For my part, I promised to purchase the stock at $50 — at least until the option expired in January.

With the stock trading at $53, I was comfortable with an obligation to purchase Nortel at $50 should it drop to that level, and the buyer was paying me a further $4.30 for granting this option. Thus, taking into account the premium of $4.30, my cost base — the price at which I would acquire each share — would be $45.70 ($50 minus $4.30). Of course, the option holder wouldn’t assign the shares to me–that is, oblige me to buy them at $50 a piece — at the expiry of the option unless the stock had fallen below $50 because he or she would gain more by selling their shares at the prevailing market price.

In this case, the option I sold would expire worthless and my gain would be $4.30 per share, the proceeds from selling the options. (Each option contract covers 100 shares). Instead of doing nothing while waiting for the stock price to fall, selling this put option would generate some revenue for me. Furthermore, in the event the stock did fall I wouldn’t suffer nearly the loss I would have had I simply purchased the shares at $53 ($53 – $50 = $3 loss). What did I forfeit for this strategy? Well, Nortel might continue its meteoric rise and I would miss out (except for the $4.30 per share I received) since I chose not to buy the stock. For instance, if the stock had climbed to $90 by January, I would have missed a $37 profit ($90 – $53 = $37). (Believe me, this has happened!)

Call options can limit loss
On other hand, if you’re bullish and don’t want to miss out on a further rise in the price of Nortel, you could simply buy the stock. However, if you’re bullish but still afraid the price will drop, say, to $45 from its current price of $53, there’s also an alternative way to reach this goal using options. You could buy a call option on the Nortel shares. This call option would allow you to control the amount you can lose but participate dollar for dollar in any advance in the stock price just as if you purchased the shares.

Here’s how: By purchasing a January call option with an exercise price of $55 you would have a profit of $35 per share ($90 minus $55) should the stock advance to $90 by the third week of January. If this happened, you would simply buy it at $55 (remember, the call option gives you the right to do just this) and sell the shares in the market at $90. Your $35 profit will actually be reduced by the amount you paid for the call option and by your brokerage costs. On the other hand, no matter how far the stock declines your loss will be limited to the amount you paid for the option — the “premium”.

The potential drawback of purchasing a call is that the option has a limited life and will expire worthless in the event the stock does nothing or declines. Again, you must decide what your goals are and how this particular stock fits into that plan.

Never exceed your tolerance for risk

Granted, there are some pitfalls and potential disasters that can befall the option trader, so having a competent financial adviser is recommended for most investors. Remember that most, if not all, financial disasters stem from money mismanagement, usually resulting from using too much leverage and assuming too much risk.

In the example shown using a put option, you can see that my strategy of selling the put was actually less risky than even purchasing the shares outright would have been. But note that I didn’t sell more puts than would get me the amount of stock I was willing to purchase (100 shares). If you’re looking to options to reduce your portfolio risk, you must be wary of this temptation to overuse leverage. Rest assured, you can easily cross that fine line from money and risk management to speculation very quickly.

As well, if you’re considering using an option strategy, be sure to look at it in light of the equity portion of your portfolio — after all, you’ll ultimately end up owning or selling the stock — and examine your opinion about the underlying stock itself.

Flexibility is always desirable in a portfolio, and options offer opportunities for refining your portfolio that aren’t always available with the simple purchase or sale of stock or mutual funds.

Douglas Fox is the author

of Exploring Options: A Practical Guide to Options Trading.