Scared of Options? Consider Them a Type of Investing Insurance

Many traders and investors are wary of options. That's a shame, because they can be an effective investing tool. Most people do not understand how options work, nor do they know that options can enhance returns while reducing risk. If anything, trading options for income or simply using them to protect your portfolio, could help long- or short-term investors to protect their investments in times of stress. Everyone remembers the huge market drops in 2008 to 2009 and more recently in 2020. Those were potentially catastrophic drops that led to substantial losses for some. But for those who held on, protected their portfolios and held onto large sums of cash -- well it turned into quite the buying opportunity. Many investors who used options as protection or hedges probably made out in a huge way. So, what are options exactly? Equity options are a derivative of an underlying security. They are made up of a strike price with an expiration date, which allows you the right to exercise an option to buy stock at a certain price. There are two types of options used: call options and put options. A buyer of call options is looking for a particular security to rise past a strike price, while a buyer of put options is looking for a security to fall below the said strike price. Now, why not just go out and buy stock rather than messing around with options? It's basically the same transaction, right? Well, yes and no. You see, buying a stock requires you to pay a full price for those shares up front. Buying 100 shares of Apple at $160 per share would cost you $16,000. An option can be bought for a fraction of the price, but there is one difference. Options have an expiration date, so you would be looking for stock to exceed a strike price before the option expires. That's a daunting task for some -- picking the right direction and the timing. But the leverage is the most attractive component of options. What do we mean here? The options contract states an option buyer controls 100 shares of stock for each option. So, buying 10 contracts of Apple at a certain price gives the buyer control of 1,000 shares of stock. That is powerful, but the other side needs to be addressed -- the timing. If this stock makes a move through a strike price before expiration, the option is said to have intrinsic value. This is where leverage comes in. Apple might move 5% up, but an option might move up 60% or more with an option that might be slightly out of the money at the start. At this level, the leverage is about 12 to one in favor of the option, if the stock makes a move above the strike price before the option expires. Buying put options is part of an expanded strategy of protection, hedging and taking advantage of downside momentum. Stocks move faster to the downside than up, that is natural. When investors are afraid, they tend to move their money out quickly then ask questions later. Most if not all investors are risk averse, and as such abhor large moves in stocks, but it's those downside moves that make our stomachs upset. Buying a put option, though, at a minimal cost helps an investor weather a storm or even potential disaster. Remember, those large drops earlier from 2008 and 2009 and 2020? Put options were acting like insurance against a disaster. Much like when we carry life, health, auto, home and fire insurance, we hope we don't need to use it, but if something bad happens we are glad to have it. The same philosophy applies here. In the second part of this three-part series on options, Lang will discuss how to easily protect your investments using options. In addition to writing for Real Money and the Action Alerts PLUS, Lang is the author of Know Your Options.

Scared of Options? Consider Them a Type of Investing Insurance

In this first of a series on options, let's take a look at why options can act as a great investing tool, once you understand how to use them.

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