Many investors and market participants fail to properly understand the use of options. In fact, most people ultimately lose money on equity options. In order to minimize loss in option investing, investors should remember the most fundamental tenant of option investing: all options are speculative bets.

When you own an equity option, you do not own the physical stock or claim on a business; you merely own the right to buy or sell the underlying security at a predetermined price. Because options are so speculative, use them sparingly and not allow them to represent a meaningful percentage of your overall portfolio. Read on to find out who should use options, and how to use them safely. (For a background on options, see our Options Basics Tutorial.)

It's Usually Best to Avoid Options
Generally, it's a good idea to avoid options unless you are extremely proficient in the mechanics and pricing of options. Most of the time, the reason investors succeed with options has nothing to do with their skill, but is merely lucky timing. Unlike stocks, options have a finite lifespan. As a result, when people employ options they are essentially making a bet on window of time. And for options, that period of time is usually between a few weeks and a few months.

Unfortunately, very few businesses have business strategies that focus on the next month or two. Instead, most businesses create value over years of effort. And often, stock prices can remain dormant for a period of time before reacting to the value created by the business. There's an 80/20 rule in the stock market: 80% of a stock price move occurs during 20% of the year. In other words, a stock that returns 20% a year could go 10 months out of the year being relatively flat and then appreciate by 15% during the last two months of year.

With this concept firmly in mind, let's consider a hypothetical scenario from the XYZ Company. On September 18, 2009, XYZ stock traded for $54. Let's say your data led you to be bullish on XYZ for the rest of the year. The November 2009 $55 option (the options that expire on the third Friday of November with an exercise price of $55) are selling for $1.45 per contract. Because the exercise price is above the current stock price, the option has no intrinsic value - the entire option premium is based on the time you have between now and November.

So let's say by the November expiration date, XYZ shares are trading for $55.50. Your option is worth 50 cents. No one is going to pay you more than the difference between the strike price ($55) and the current price ($55.50) for the option. The net result is loss over 50% of your capital. Let's say at the end of December, XYZ shares trade for $58 based on reasons supported by your data. You were right, but you still lost money because the shares didn't react during your option time.

LEAPS: The Quick Fundamentals
Long-term equity anticipation securities (LEAPS), are the fancy name for a long-term option on a common stock. Generally, LEAPS have a duration of two years, but sophisticated investment firms can create longer dated LEAPS.

The appealing quality of LEAPS is obviously the length of time imbedded in the option. The common mistake investors make with options is not making the wrong call, but not having enough time in the option to see that strategy play out.

LEAPS provide the investor with sufficient time, so that usually is not the issue. Two years should be sufficient time for any business to regroup from most operating environments. The issue of whether to consider a LEAP sits squarely on the underlying business.

Intelligent Speculation
The use of LEAPS is most prudent and successful when it is most businesslike. The advantages of buying a LEAP versus the outright stock is of course the capital required. Buying LEAPS would require a fraction of the capital needed to buy an equivalent amount of stock. Yet the disadvantage of owning the LEAP versus the stock is that if your analysis is wrong, you could lose 100% of your capital. So, only use LEAPS when the odds of success are skewed heavily in your favor. (To learn more, check out Using LEAPS In A Covered Call Write.)

In other words, before you invest in a long-term option, ask yourself this: Would you invest in the common stock? If the answer is no, then you should immediately dismiss any consideration of investing in the underlying LEAP.

The reasons for investing in any stock comes down to some very fundamental considerations:

  1. Is this a quality business?
  2. Does the company's price offer me a margin of safety? In other words, is the business undervalued?
  3. And finally, does the business have the ability to earn more profits over the next few years?

If the following three considerations are met, then it is possible to consider investing in the LEAP instead of the underlying equity.

Examples: Past and Present
Despite the turmoil surrounding the financials back in the spring of 2009, along with the carnage there were some quality financial institutions selling at prices that were completely irrational. Two names that come to mind are Wells Fargo (NYSE:WFC) and American Express (NYSE:AXP). Despite the tougher business environment they faced in March 2009, WFC and AXP were trading at around $9 and $12 a share, respectively. Keep in mind that these companies were favorites and major holdings of legendary investor Warren Buffett.

At the time, you could have bought January 2011 call options on both companies. Given there severely depressed prices and nearly 20 months worth of time, it would have made sense to buy the options at prices a bit above the current share price. You could have bought the Jan 11 $20 strike WFC options for about $1 and the Jan 11 $25 strike AXP options for a similar price. Considering that both WFC and AXP were trading a lot higher than both of these strike prices in the past, any return to normalcy could boost the share price. And instead of using $9 per share in the case of WFC, the option only cost you $1. The following fall, both options sat above $10 each.

An Option Is Still an Option
Whether it's a LEAP or not, an option is an option and they are all speculative. While you wait, a downward price move in the equity will likely lead to significant paper losses in the meantime. It's not uncommon to see options down 60% to 80% in a very short period of time. They are volatile instruments. LEAPS help reduce volatility because of the longer time but if you can't stomach such volatility (which in most cases with options is guaranteed) then think twice about using them.

However when used appropriately under the right conditions, LEAPS can provide very lucrative upside potential. (For more, read Rolling LEAP Options.)

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