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Examining your options
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October 5, 1999: 11:43 a.m. ET
Trading options doesn't have to mean speculating if you don't want it to
By Staff Writer Alex Frew McMillan
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NEW YORK (CNNfn) - Only around 5 percent of retail investors get involved in options trading. But used correctly, trading options can be a very effective planning tool, financial advisers say -- it's just that they take time and a fair bit of homework to understand.
"People need education to know that these instruments exist and to know what to do with them," said Brad Zigler, managing director of options marketing, research and education at the Pacific Exchange. "That takes a little bit more time and a little bit more effort than some investors are willing to grant."
Options volumes have increased this year, partly as result of U.S. exchanges being able to list each other's options. There have been some multiple listings since the early '90s, but the exchanges still had a gentleman's agreement not to trade each other's most-popular issues.
In August, that fell apart. The greater competition has improved prices and played into the general interest in investing.
Still, "the numbers are growing but not nearly at the rate of growth in stock-market usage," Zigler said. The largest exchange, the Chicago Board Options Exchange, set a volume record in September, averaging 1 million contracts a day, and the industry as a whole is growing at an annual rate of near 25 percent. But many investors are put off by options' risky reputation.
"Some people are unable to get over their prejudices. … The culprit is the constant characterization of options as gambling," Zigler said.
So what are options?
Options are a type of derivative, vehicles whose value stems from an underlying investment. That word alone may be enough to put many people off. Options are also different from investing in the stock market, in that option trades always have a winner and a loser. If you're going to win with options, that likely means you have to beat a professional options trader, a difficult but not impossible task.
"It can be done, because they're making probabilistic bets," said Ronald Johnson, an investment consultant in Palm Harbor, Fla. While the traders are typically speculating, as retail investors can, very conservative investors can use options to protect themselves.
There are two basic types of option -- calls and puts. Calls give the buyer of the option the chance to buy a stock at a certain price through a set expiration date. If they're not exercised, they're worthless. The buyer of the call hopes the stock rises above their strike price, the price they can exercise at. If the strike price is $50 and the stock rises to $52, it's what's called "in the money" by $2 a share.
Puts work the other way around, giving the buyer of a put the option to sell stock at a set price. The buyer of a put hopes the stock falls, making the chance to sell the stock at a higher price worthwhile. Both calls and puts are sold on 100-share lots.
U.S. investors can also buy and sell the options before expiration. The buyer always has the option of exercising or letting the option expire, which limits the downside. Most options are short-term, a year or less, though the longest last up to three years.
How can they be used?
"They're beautiful things to control risk," Johnson said. An investor can write a covered call, or a call on stock they already own, if they predict the price won't change over, say, the next three months. If that proves correct, the investor gets the premium from the option and keeps the stock.
That provides incremental income if the market stays flat or cushions a loss. Of course, if the stock rises, the investor will more than likely be forced to sell the stock.
"There's some discipline in that because many investors have some problem knowing when to sell stock," Zigler said. There are ways to avoid selling the stock, too -- some investment advisers recommend buying the option back at that point and possibly reissuing another one.
By buying a put, an investor that thinks a stock is overvalued will be able to force someone to buy at a higher price down the road. That can be safer than selling a stock short, because the price of the put is fixed, and investors can let the option expire if it moves against them.
An investor who writes a put on a stock they think will dip and then rebound can generate the premium from writing the put, and they'll have the put exercised against them at the price they think it's worth. That's useful for an investor who notices a stock has price support, wants to buy at that price, then expects the stock to rally.
That has an advantage over a limit order, which isn't guaranteed to get executed. Of course, you have to able to afford buying the stock at the price of the put, Zigler pointed out.
So why do people view them as risky?
The notion that options are not a far cry from gambling stems from the fact that they provide much greater leverage than investing in stock. Even with a margin account, an investor can at most double their buying power with stock.
Options are typically priced at 10 percent or less of the actual value of the underlying shares, meaning investors can increase their buying power -- and potential risk -- to 20-to-1 or even 100-to-1, Johnson pointed out.
Johnson thinks most day traders would be better off speculating with in-the-money options than stock. But for conservative investors, he said options are great devices for people who hold large blocks of stock they can't or don't want to sell -- executives that are locked into holding stock, or people who have stock from a buyout.
Stan Hargrave, a certified financial planner with IMS\CPAs in Riverside, Calif., says options are diverse tools.
"You can use the hammer to build a house, or hit someone over the head. Learn to use the hammer," he said. "There's enough leeway for people to use them in a very positive way. Too many people hear about the speculative nature of these marketplaces."
He helped a couple that had inherited stock and didn't want to sell for tax reasons. But the stock was only generating 1 percent a year in dividends and the price wasn't increasing. By setting up a program for them to write covered calls on the stock, they boosted their cash flow to between 8 and 10 percent on the stock, he said.
Greg Zandlo, a certified financial planner and president of North East Asset Management in the Minneapolis suburb of Coon Rapids, only advises clients with a securities portfolio of more than $100,000 to think about options.
If you use options to get more leverage, you have to be prepared for the market to move against you quickly and sharply. "It's definitely not for everybody," Zandio said. Many people don't have the psychological makeup for that kind of risk.
"But the effective use of puts or calls to hedge against some things, that's a more normal situation for an investor," Zandio said. Options are available on indexes as well as stocks, currencies and commodities, and he pointed out an investor with a large stock portfolio could offset risk of a decline by buying puts on the S&P 500 or Nasdaq 100.
"The way I use options for client portfolios is as more of a hedge. We don't look to make a killing on them," Zandio said. "We pretty much know whether, for Mr. and Mrs. Main Street, this is in their best interest. Most often it is not. If you want them to understand what they're doing, and they really don't, you're barking up the wrong tree."
For more information about options
The four U.S. exchanges for trading options -- the Chicago Board Options Exchange, the American Stock Exchange, the Pacific Exchange and the Philadelphia Stock Exchange, in order of trading volume -- all have educational material explaining options on their Web sites.
There's been persistent merger talk among them, and they may soon have competition from a fifth, electronic market. In February, the upstart International Securities Exchange filed to become an exchange. The public comment period has finished, and the ISE hopes to start trading by next March 24 at the latest. The competition may push execution costs and commissions down more, making options trading slightly more attractive.
For those who want to learn more, the four exchanges fund an educational wing, the Options Industry Council. It conducts more than 100 free seminars each year and provides videos and software for both investors and brokers. Its Web site has a reference page with software downloads and a list of recommended reading.
The CBOE has its own educational arm, the Options Institute, which also runs seminars, some free and some for a fee. Investment advisers recommend the "Options Toolbox" software, which investors can download free from the CBOE Web site. The OIC also provides the Options Toolbox or a free download to investors who register.
The software has a handy model for pricing options, and it lets investors practice trading a dummy portfolio of options, something investment advisers highly recommend.
The investors who do use options clearly make a habit of it -- retail investors account for around 55 percent of options trading, according to the OIC.
"They are the most flexible instrument in the world. You can use them to protect your portfolio. You can use them to speculate," Johnson said. But options are often more complex than stock. "This is a market they should really investigate before they get involved," he added. 
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