CHAPTER 10

Using Options to Turbocharge Your Returns

For many investors, options are scary. These investors have heard horror stories about people who got burned trading options, or that they’re complicated, or that they’re not for the little guy.

There are complex options strategies, and people do lose money when they speculate (there are also many investors who make money) with options. Most people who lose money trading options do so because they buy options. In a moment, I’m going to show you how to be the seller, the person who is more often on the winning side of the trade.

The strategy that I’m going to show you is simple, carries no risk to your principal (only opportunity risk), and can boost your returns by double digits annually.

First let’s go over definitions of the two kinds of options: puts and calls.

Let’s look at an example.

Shares of Microsoft are trading at $26. An investor buys the January $30 call for $1. This means the call buyer has the right (but not the obligation) to demand the shares of Microsoft at $30 from the call seller at any time between now and the third Friday in January. (Options expire on the third Friday of the month.) That $30 price is called the strike price—the price at which the seller of the call agrees to sell the stock to the buyer if demanded.

Why would someone want to enter into a contract to buy shares of Microsoft at $30 in the future if today he can buy them at $26? Because he thinks that by January, the stock is going to be higher than $30. Maybe he thinks it will be $35 by then, and to secure the right to buy it at $30, it will only cost $1.

If Microsoft is above $30 by January, the call buyer can demand the stock at $30, or he can sell his call at a profit. If the stock is trading at $35, he should be able to sell the call for at least $5, turning his $1 per share investment into $5.

Buying the call allows him to participate in Microsoft’s upside while risking only $1 per share instead of $30. However, unlike owning Microsoft shares, the call option has an expiration date.

If the stock does not go above $30, the call expires worthless and the seller of the call keeps the $1.

Puts act the same way, only the buyer of the put has the right (but not the obligation) to sell the stock at a certain price. If an investor owns Microsoft at $26, he may buy a $24 put to limit his losses.

If tomorrow it’s discovered that Microsoft’s code has been secretly stealing the personal information from every PC user in the world, the government shuts the company down and the stock falls to zero, the buyer of the put can force the seller to buy his shares at $24.

If you want to learn all about options and strategies, there are tons of books on the subject, including Get Rich with Options (John Wiley & Sons, 2007) by my friend and colleague Lee Lowell.