One of my friends made an offhand comment about how options are dangerous and should be avoided. I make a case for a contrary opinion — options are a sophisticated tool that can be very useful if you understand and manage the risks properly.

Let’s look at a few specific uses of options that we might find useful.

Writing Covered Calls

Suppose I own 100 shares of GOOG (currently $378). I feel like it will do well in the future, but expect it to be flat for the next year. I can sell one option (January 2007 $400 call) for $5200. Since I own $37,800 worth of stock, I can take $5200 off the table and am only penalized if GOOG shoots above $400 again (in which case I?d probably just buy more shares).

Buying calls to fulfill a strategy and limiting your money at risk

I have a trading system that signals a buy of 100 shares of Chesapeake Energy (CHK) today with a 25% trailing stop loss. Since CHK is at $30 today, that would mean my stop loss is at $22.50. Worst case, that would mean a loss of $750.

If my trading system says that I will hold CHK for 6 months or less and the price should go up by at least 25%, I might consider buying a July 2006 $32.50 call for $210 instead of risking $750 on the cash market. I could either accept a lower risk ($210 loss instead of $750 loss) or increase my upside exposure and buy 3 options (3 x $210 = $630, controlling 300 shares with less risk).

Hedging a long position with puts

Suppose I own 100 shares of TGLDX (currently $47.71), a gold mutual fund. I?m worried about the prospects for gold over the next 6 months, so I want to limit my downside exposure. I might consider buying puts on Newmont Mining (NEM, $58). A Sept 2006 $50 put would cost me $215. For only $215 I would limit the downside on $4800 worth of a long-position.

Using options to avoid short-term capital gains

Suppose I own 100 shares of Office Depot (ODP, $36) and bought 11 months ago at $20/share. That means I have $1600 in profit so far (an 80% gain)… but I?m really paranoid about the short term (next 3 months) of the stock market in general and for ODP specifically. I don?t want to sell and take short-term capital gains (33% x $1600 = $530 in taxes), so I buy a July 2006 $30 put on ODP for $55 and hedge my downside exposure.

Potential Problems:

  • Which direction, how much, and by when (3 things that are hard to predict)
  • Lots of leverage
  • Lack of liquidity
  • Large/wide spreads
  • Higher commissions,
  • Lack of tool support (Quicken, XLQ, etc.)
  • Harder to set stop-losses
  • Less well understood