Options can be risky and complicated, but they don't have to be either one, and they can potentially bring a high return.
In a previous stop in my career, I was lead editor for a participant newsletter for a leading retirement provider. Although I did not technically act as a “registered representative”—a person who conducts business in securities—I did, as editor, provide some investment advice, and thus I was required by the company to obtain my Series 7 license from the Financial Industry Regulatory Authority (FINRA).
The portion of the Series 7 exam that gave me night sweats was the lengthy section on options, which are securities that give the investor the right to buy or sell a security at a specified price within a specified period. Options can be bought or sold on stocks, bonds, and futures, and there are many different types of options, including calls and puts, spread options, straddles, index options, foreign currency options, and interest rate options. If I haven’t lost you already, bear with me.
Options can be risky and complicated, but they don’t have to be either one, and they can potentially bring a high return depending on the type of option, the initial investment, strategies used to “hedge” potential gains or losses, and movements in the market, among other factors. They can also bring unlimited losses. That’s a scary word: “unlimited.”
Although I often hesitate to use gambling metaphors when talking about investment strategies, this is one I can’t resist. If you have never played the game of craps before and you approached a lively craps table, you might be completely overwhelmed. There are a seemingly endless number of potential bets, and each can differ in terms of odds, duration of the bet, win and loss conditions, and more. But craps doesn’t have to be complicated. The more you know about the rules and the odds, the better your chances of making a successful wager. Even knowing very little, there are potential wagers that are relatively simple. Placing only a “pass line” wager is straightforward, easy to understand, and limits your losses to your initial investment. Other wagers can grow significantly more complicated.
Option investing, too, can be simple, such as a long call, in which an investor buys the right to buy a stock at a given price before a set expiration date. But they can grow infinitely more complicated. Straddles, for example, are an investment in which a buyer or seller is purchasing an option with the expectation that the market price of the underlying security will either rise or fall. Long straddles are profitable when the price of the security is volatile in either direction. An investor who sells a short straddle is hoping the price of a security remains stable.
Financial advisors and registered representatives are required to have a basic understanding of options—and their risks and rewards—as part of the FINRA licensure process. And they’re required to accurately tell you about those risks. But don’t take it on faith that the advisor or broker you’re working with is an expert on options. As I mentioned two paragraphs ago, there are some types of options, such as selling an uncovered call (also known as a “naked call”) in which the investor’s potential loss if the option is exercised is unlimited.
If you didn’t know anything about craps, you probably wouldn’t approach a table with the mortgage money and start laying down wagers you were unfamiliar with. Investing in options is not “gambling” in the strictest sense, but doing it successfully does involve being informed about potential gains, losses, initial investments, and the conditions under which your investment will gain or lose value.
Not all options are as risky as uncovered calls. In fact, there are some available options and some hedging strategies, that make options investing quite low-risk indeed. The message here is not to avoid options investing at all costs. Rather, the message is the same as it is with all investment strategies; understand the investment—and its accompanying risks and returns—before jumping in with both feet.