Are options a good investment?

Options are not really an "investment," per se. They are a useful vehicle for trading (as opposed to buy-and-hold) and for hedging.

Just to make sure everyone is on the same page, let's talk about what options are (and I'll talk only about stock options).

In its simplest form, an option is the right (but not the obligation) to buy or sell a security, called the "underlying" for a specific price. A "call" options means the right to buy, a "put" option means the right to sell.

Here's an example: Apple was trading at $111.79 on Friday. That means I'd pay $11,179 to buy 100 shares of that stock. If the price of Apple goes up, say, to $115.00 per share, the value of that holding will be $321 higher. That would be an increase of 2.7% in my investment.

If my primary motivation for buying Apple is to see it increase in value for a profit over some specified time horizon, I could also buy a call option with a "strike price" of $112.00, expiring June 16. That means that I would have the right to buy 100 shares of Apple per contract for $112 per share. If Apple goes to $115 by the time the option is due to expire, on June 16 of next year, I'll be able to buy a $115 stock for $112. That right would cost me $835. At expiration, the option would be worth roughly $1,135. I could either buy the stock for that price, or sell the option for a $300 profit. My investment would have increased by 35%.

But what if the stock went down? Then the option would expire worthless, and I'd lose the $835 I paid for it. Risk vs. reward.

A "put" option works in much the same way, except the buyer of a put is banking on the underlying security declining in value in order to profit.

Sounds simple, right? You make an educated guess about whether a stock is going to go up or down, then you buy one or more call or put option contracts and cross your fingers that you've guessed right.

Welcome to Casino Capitalism.

But wait! There's more! Options have been around for literally millennia. Grain merchants had to buy their inventory far in advance, and they wanted to be protected against any price decrease, which could wipe them out their business. So they found someone willing to write them an insurance policy against a possible decline in grain prices. If the price of wheat were to drop, that insurance policy (a "put" in today's world of options) would gain in value, offsetting the drop in value of their crop. This is called "hedging." The person selling the hedge hoped that the price would NOT drop, in which case he would get to keep the premium when it expired.

Does this sound like an "investment?" I'd say no. It is a business-and if you are confident in your ability to predict the direction of a security over a specific time, you will be confident that you could successfully trade options. Your confidence may not be justified, but in this type of trading, called "directional trading," your success is directly tied to your ability to predict the future performance of the market. Would you have believed in 2009, when Apple was trading below $14.00, that it would reach $131.00? If you had that belief (and the financial wherewithal) to buy it then, where might you be today?

For most people, trading options is probably not a good choice. The rate of return can be spectacular, but the risk of loss is high. NO ONE should consider trading options in any manner using money they cannot afford to lose.

With that simple tutorial and disclaimer out of the way, I'll say that there are many subtleties, nuances and strategies involved in trading options. There are credit and debit spreads, straddles, strangles and iron condors. There are calendar calls and diagonal spreads. There's Delta, Gamma, Rho, Theta and Vega ("the Greeks"). There's "assignment risk."

Do you get the idea that it's not exactly brain surgery? You'd be right; brain surgery is a piece of cake.

With all that said, I'll say that as a business (not an investment, although capital is required), option trading is fascinating and remunerative. But just as with other businesses, option trading demands a high degree of knowledge, skill-and discipline.

I'm reluctant to say "good luck," because option trading requires far more than that, but, well-good luck. I hope this was useful.


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