AS A KID, my most revered manmade invention was not a train or a record player, but rather the Swiss Army pocketknife. When I saw it for the first time at a friend’s home, I was fascinated that it could cut paper, open bottles, file nails and more. I marveled at the engineering beauty and wished I had one of my own.
Years later, I was in Switzerland for a short business trip and had some free time for souvenir shopping. I saw a Wenger Swiss Army knife and fondly remembered my childhood wish. Without a second thought, I bought one that had a dozen or so attachments.
After returning home, I was eager to show off my new toy to my wife and daughter. I used it wherever I could. My daughter was amused to discover the child in her dad. My wife teased me about my sudden interest in kitchen chores. Sadly, a minor mishap soon ended my excitement.
My wife was trying to open a jar that was stubbornly jammed. I offered to help and took out my pocketknife to showcase its versatility. The first few attempts failed, and yet I didn’t want to give up on my favorite tool. I opened more blades and applied pressure. The knife slipped and I badly cut my hand.
I recalled this incident a few years ago, when I was learning about financial derivatives, and specifically stock and index options. I was intrigued by Warren Buffett’s view of derivatives as “financial weapons of mass destruction.” I researched online, attended webinars and even studied a 1,000-page book. It struck me that options were the Swiss Army knife of investment tools. They’re elegant, versatile and nifty, but also deceptively dangerous even for experienced investors.
Their elegance lies in the simplicity of the basic concept. An option is a timebound contract between two parties to either acquire or sell an underlying security at a preset price. The option buyer pays an upfront cost—the option premium—for the right to do the actual trade. The buyer hopes that the price of the underlying security will move favorably before the contract expires. The option seller gets the premium. In return, the seller is contractually obligated to honor the trade, which occurs at the buyer’s discretion. Options give investors the ability to bet that a stock or market index will be above or below a certain price within a certain time period.
How does it work in practice? Let’s take the example of Bob, an active stock investor. Bob is bullish about Contoso Corp. He’s convinced that the stock will soon break out from its current $50 share price, so he buys an at-the-money call option that’s valid for a month. The option gives Bob the right, but not the obligation, to buy 100 Contoso stock at today’s price for one month. For this limited time privilege, Bob pays an option premium of $3 per share—a total of $300 plus commission for his option trade.
Why does Bob buy a call option instead of buying the stock outright? Perhaps Bob is waiting for his monthly paycheck before coughing up $5,000 for the stock. Or maybe he wants to limit his potential loss. There can be many reasons Bob prefers the call option to buying the stock.
Who sells the call option to Bob? Let’s say it’s Sam, who owns 100 Contoso shares. Sam doesn’t think that the stock is going anywhere soon. He’s content owning Contoso for its regular dividend, but he doesn’t mind earning an extra $300 by selling the call option to Bob. Sam takes on the short-term obligation to sell his Contoso shares to Bob at today’s price, should Bob want them anytime this month.
This example can play out in a few possible ways. If Bob’s wish comes true and the stock rallies before the contract expires, he can exercise his right to buy the shares from Sam at the old price of $50. Since Contoso’s rally raises the market value of the call option, Bob can instead sell the option to someone who expects the rally to continue further. On the other hand, if the stock stays at $50 or falls in price, the contract expires worthless. Bob loses the entire $300 premium.
The simplicity of options ends there. Accurately predicting the direction and magnitude of price movements within a short time period is no small feat. The option pricing model is a daunting beast to master. Tax treatment can get complex, too, not to mention possible surprises because of the wash-sale rule.
Options are often touted as a versatile tool for both aggressive and conservative investors. Sweating over the possibility of an imminent downturn? Protective puts can be your portfolio insurance. Want some extra yield from your portfolio? Covered calls can ride to the rescue. There are numerous well-documented strategies for many common situations. Custom strategies for specific situations can be created, too. The choice is endless.
How useful are these strategies? The Chicago Board Options Exchange, the creator of listed options, maintains several indexes to benchmark a few common option strategies that use the S&P 500 as the underlying asset. These include the PPUT index that mimics the performance of a hypothetical S&P 500 portfolio, hedged by protective puts. They also include the BXM index, which tracks an S&P 500 portfolio in combination with covered calls. Detailed analyses of these indexes are regularly published.
Hedge funds use options widely, as do many professional money managers and institutional investors. But should individual investors like you and me dabble in options, beyond the occasional experiment for entertainment or education? The scar left by my Swiss Army knife is a constant reminder of a valuable lesson: A beautiful and versatile tool can also be very dangerous. Result? After all my research, I make occasional use of options—but I’d be reluctant to recommend them to others.
A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Thanks for Nothing, Blessing in Disguise and Bonding With Bonds. Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.