Options Investing Needn't Confuse

Looking to protect your portfolio against a sudden market pullback or bet on a company with only a fraction of the cash it would take to buy stock? You've got options, albeit ones that can create risk as well as guard against them.

Stock options, that is. But you better be sure you understand them. Even clued-in investors should rely on options mostly for portfolio protection, not to ramp up returns in a big -- many financial planners would say dangerous -- way. The bottom-line caveat is the same-sense caution your parents gave you: Everything in moderation.

Also, because each option carries a purchase price that you pay in addition to trading fees, cost-conscious investors may never feel comfortable with options. "Our view is that you control risk through asset allocation," not options trading, says Jason Graybill, a portfolio manager at Abner, Herrman & Brock Inc.

For years individual investors avoided options, which are actually contracts struck between two parties that give the holder a right, not an obligation, to buy or sell an underlying stock, index or other asset at a set price and date. This year, all kinds of investors have jumped in, spurred by an uncertain stock market.

The volume of stock and stock-index options contracts traded so far in 2005 is up more than 25% over last year, according to Options Clearing Corp., which processes trades. At Charles Schwab Corp., clients placed 35% more options trades this year through November than during the same 11-month period last year, according to the San Francisco discount brokerage. Another broker, Ameritrade Holding Corp. of Omaha, Neb., says growth of customer accounts enabled for options trading now outpaces those that don't allow such activity.

Many of these investors are engaging in the most basic types of options transaction, trying to put a floor underneath a stock bet or give themselves an opportunity to pick up shares at a bargain price. For example, say you are a proud shareholder of General Electric Co. but are worried about the blue-chip conglomerate's bet on MSNBC (GE's NBC unit Friday said it would up its stake in the cable network to a controlling 82%). You could call your broker up and buy a "put" option on GE shares, which now trade at about $35. A put on GE at that price can be had right now for 25 cents and is good through late January, meaning that at any time over the next several weeks you would have the right to sell GE shares for $35 each, even if the stock dropped below that price. Alternatively, a "call" option allowing you to make a bullish bet on that same stock goes for about 85 cents, giving the holder a right to buy the stock at $35 no matter how far it climbs.

Options are priced at a small portion of the underlying asset and cover various terms. Keep in mind that the above examples do not include the trading commissions that brokers tack on to each options transaction. At Schwab, for example, an active trader would pay a one-time fee of $9.95 to buy those GE puts, plus another 75 cents per contract. These extra fees can add up, especially if you bet wrong.

"If you keep on losing a limited amount of money on a regular basis, you are still going to get wiped out," says Michael Schwartz, chief options strategist at Oppenheimer & Co.

Also, keep in mind unlike stocks, options lose value as they approach their expiration date, a phenomenon that professionals refer to as "time decay." And an option never exercised is tantamount to paying for insurance you never make a claim on.

For the truly bold, options also can be used as an income generator.

At optionsXpress Holdings Inc., many customers are employing a "buy-write" strategy, says David Kalt, the online brokerage's chief executive. These investors buy a stock and simultaneously sell a "call" option against it, meaning they are selling someone else the right to buy that underlying stock at a preset price. This trade can be repeated, selling the call again and again.

It works well, especially if the market is sitting still, and can actually help offset a decline in the stock. But if the underlying stock suddenly rallies, whoever bought the call will most likely exercise, and the buy-write investor will have to sell that stock, having lost the opportunity to collect all its upside. A number of investors were stung by this scenario in the late 1990s when stocks took off, recalls Mr. Schwartz.

Of course, the buy-write play is varsity options trading. Those investors looking just to cap a portfolio's downside should stick with junior-varsity dealings.