I've heard that options are risky investments. Is that true? How do they work? — Tara, Connecticut
Options have the unfair reputation of being considered riskier than other investment vehicles. For instance, in a book written by a well-respected duo of female financial advisors who cater to divorced and widowed women, there is a table that classifies types of investments. Whereas they consider stocks to be moderate-risk investments, they include options in the high-risk category along with junk bonds, highly leveraged real estate and penny stocks. I consider this classification misleading, if not inaccurate.
Although options can be risky when used for speculative purposes (meaning that you are betting that the price of a stock will rise or fall by a specified amount within a certain amount of time), the strategies I teach in my book, “Every Woman Should Know Her Options,” use options to reduce risk when investing in the stock market. Beyond that, they do a nice job of generating income that can be spent or reinvested to enhance stock returns.
A stock option gives the holder the right, but not the obligation, to buy or sell shares of a stock at a specified price on or before a specified date. Options come in two varieties, calls and puts, and you can buy or sell either type. For example, if you buy one call option, you pay a premium for the right to buy 100 shares of stock at a designated price on or before a specified expiration date. You might do this if you think the price of a stock will go up in the short term.
If you buy a put option, you pay a premium for the right to sell 100 shares of stock at a designated price on or before a specified expiration date. You might do this if you think the price of a stock will go down in the short term. These can be risky strategies because you can lose your entire premium if the stock fails to increase (or decrease in the case of a put) in price by a certain amount within a certain period of time. Contrast that with buying actual shares of stock where you lose your entire investment only if the company goes bankrupt. If these are the strategies that the financial advisors were referring to, then I agree with them.
However, the option strategy they clearly didn’t consider is the one I use most often and is called “covered call writing.” It is less risky than buying stock by itself, and you can even use it in your Individual Retirement Account (IRA), including a Roth IRA. A covered call consists of two steps: You buy shares of stock (or use stock you already own) and then sell call options against those shares of stock. You can use either stock or exchange-traded funds (ETFs) as the underlying security. A small percentage of financial advisors (including myself) specialize in this type of strategy, but it is also something you can learn to do on your own — with some education and coaching — in a self-directed brokerage account or IRA.
Many people I know buy a house or apartment and rent it out for supplemental income. Frankly, this idea never appealed to me because it just seemed like a lot of work. You have to find tenants, take care of maintenance issues and deal with the bank. If your goal is to generate income, then I encourage you to consider “renting out” your stock by writing covered calls. It is so much easier, faster and more convenient than dealing with real estate. You just need a computer, Internet connection and some knowledge.