Options belong to the broad class of financial instruments known as derivatives, described by Warren Buffett as, "financial weapons of mass destruction." While it is certainly not advisable for a young investor to dabble in complex over-the-counter derivatives, exchange-traded or listed options such as equity and index options have many benefits if used prudently. Here are five reasons why every young investor should explore trading options.
In Pictures: 10 Options Strategies To Know
1. Investment Opportunities with Limited Capital
The average young investor has limited capital to invest, as he or she is quite likely burdened with student loans, a car loan and rent payments while working at one or more entry-level jobs. For such cash-strapped young investors, options are a great way to get into the markets while plunking little money down - something that also limits their potential loss or exposure.
Consider a savvy young investor who is bullish on General Electric (NYSE:GE), which is trading at $19, and expects it to rise to $23 over the next year. While a minimum market lot of 100 shares would cost $1,900 plus commissions, the investor could instead buy long-term options known as Long Term Equity Anticipation Securities (LEAPS) on GE for a fraction of the full cost of the shares, while retaining all the upside if the stock does move higher.
For example, the LEAPS expiring in January 2012 with a strike price of $17.50 are priced at $3.35, so one option contract of 100 shares would cost $335 plus commission, or less than 20% of the price of buying 100 shares. If GE does reach the investor's $23 target by January 2012, the LEAPS would be worth at least $5.50 by that time, for a return on investment (excluding commissions) of 64%. A similar stock investment strategy would provide a 21% return.The downside is that if GE does not perform as expected and falls below the $17.50 strike price by January 2012, the LEAPS would expire worthless. In this case, the investor could use the capital loss on this option transaction to offset capital gains on other trading activity for tax purposes. (To learn more about this options strategy, check out Long-Term Equity Anticipation Securities: When To Take The "LEAP"?)
2. Young Investors Have Time on Their Side
Like any investment, options can be risky. But young investors are in a terrific position to take calculated risks, because time is on their side. Risk-taking ability diminishes with age, as people are burdened with mortgages, spending on children's education, saving for retirement and so on. The time to take calculated risks, whether using options or other instruments, is when you are young and can afford to lose a little money. (See The Seasons Of An Investor's Life for more information.)
3. Outsized Upside Potential
Consider the hypothetical case of a biotechnology company whose main drug is in the final stages of clinical trials. Assume that the stock of this company is languishing at $5 because investors are skeptical about the drug's chances of success. If the results of the clinical trial are positive, the stock may soar two or three-fold in a manner of months. An investor with the foresight to have loaded up on cheap call options on this stock before it surged would reap a huge gain on the option position, with a return on investment of 500% or more. Instances like these do occur in the stock markets, and while it is no easy feat to identify such trades, the possibility of such outsized gains makes options an exciting investment avenue for the young investors. (To learn more about investing in pharma, read Measuring The Medicine Makers.)
4. Hedge Downside Risk
So you've built up a little nest-egg that you intend to use as a down payment for your first home. While you intend remaining invested in the equity markets, you are a tad concerned about the possibility of losing your hard-won gains if the markets turn south. Options such as index puts can help you hedge your downside risk. While there is a cost attached to using them, think of it as a cost of insuring your portfolio if the markets tumble. (For more on handling downside risk, check out Practical And Affordable Hedging Strategies.)
5. Collect Premiums and Increase Portfolio Yield
Because young investors can assume a certain level of risk, they should consider the use of relatively conservative option writing strategies such as covered calls and cash-secured puts to collect premiums and increase the yield on their portfolios. Since the majority of options expire unexercised, the odds of success are on the side of the option writer. It would be a fallacy to view collecting premiums for writing options as "money for nothing," since there is a degree of risk involved in any option strategy.
For example, in covered-call writing, one risk is that your best stocks may be "called away." When writing cash-secured puts, the major risk is that you may be saddled with stock that turns out to be worthless. However, writing covered calls and cash-secured puts are a suitable way for the risk-tolerant young investor to boost portfolio yield by collecting juicy premiums.
The Bottom Line
Because they are lumped in with complex OTC derivatives, options are perceived to be riskier than they actually are. However, listed options such as equity and index options have several features such as limited exposure, upside potential and ability to boost portfolio yield that make them especially suitable for young investors. (To learn more, check out our Options Basics Tutorial.)
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