With a little foresight, investors can use options to limit risk

DALLAS — Francis Nelson spends most mornings puttering in the begonia beds that surround her modest Dallas home.

But gardening is just a mind-clearing diversion for her real passion — buying and selling stock options. This 69-year-old grandmother hardly looks the part, but she represents a new generation of options traders — average folks who have had it up to here with traditional brokers.

“I just got tired of paying someone to lose my money,” Nelson said. “I got into options because at least it was different from what I had been doing, which was lose a lot of money.”

Nelson has discovered what many other investors have in recent years: When used properly — and conservatively — options can help limit risk and boost returns on stock investments.

Apparently, the word is getting out. The daily average trading volume of options contracts is soaring. About 5.6 million contracts trade daily on the various options exchanges, an increase of about 1 million contracts from the previous year, according to the Chicago Board Options Exchange (CBOE).

Investors are piling into seminars to learn about options, and they are opening brokerage accounts online that allow them to buy and sell “puts and calls.”

“Investors understand the product a lot more than they did,” said Marty Kearney of the CBOE, where most options trade. An option is the right to buy or sell a stock for a specified price on or before a specific date.

Buying a call option — the most common contract — is the right to buy the stock, and a put option is the right to sell it. Option contracts are traded in 100-share increments.

The buyer of one call option purchases the right to buy 100 shares of XYZ Co., which are selling for, say, $48, for a slightly higher price (the strike price) in the future.

The buyer of one “XYZ October 50” call option has the right to buy 100 shares of XYZ at $50 a share until the September expiration date. The buyer pays a premium for this right, say, $2 a share, or $200.

If the underlying stock price rises to, say, $55 a share before the expiration date, the buyer will exercise the option and make a profit of $3 a share — $5 on the price rise less the $2 premium — or $300.

Many investors like buying call options because it allows them to control a lot of shares of stock for a relatively small amount of money. In the above example, an investor would have had to pay $4,800 to own the 100 shares of XYZ stock outright.

“An options investor doesn’t have to tie up so much money,” Kearney said.

There is a hitch, though. If the stock price languishes below the strike price until expiration, the option expires worthless, and the investor loses the $200 investment.

But Kearney says there is another way to look at that. While it’s true the investor would have lost $200, the loss would have been much greater by owning the shares outright.

“By owning the option, an investor has the opportunity to profit from an upward move in the underlying stock with very little capital at risk,” he said.

Obviously, buying a call option is a bet that the stock will rise. This strategy is for those who are bullish on a stock and a little adventuresome, too.

Cautious investors like Nelson need a more conservative strategy. And she found one.

Instead of buying a call option, investors can sell a call. That’s mainly what Nelson does. Here is how that works:

First, she must own the underlying stock. And let’s say stock XYZ is priced at $40 a share. With this strategy, Nelson sells the call option and receives a cash premium for doing that.

By selling the three-month XYZ 45 call, she agrees to sell the stock at $45 if it moves that high in the next three months. For agreeing to sell at this price, she is paid a premium of, say, $1.25 per share, or $125 for one contract of 100 shares.

That means even if the stock price moves to $50 a share, she still has to sell for $45. But she is being paid for agreeing to do that.

“I’m basically giving up some of the upside potential in exchange for the premium,” Nelson said.

She keeps the premium no matter what direction the price takes, and she keeps any gains up to the $45 strike price.

This is one of the most conservative options strategies and a nice way to add some income to a portfolio.

Nelson said she has averaged a 13 percent annual return over the last three years of selling call options.

Like many options traders, she developed her strategy by attending a seminar on how to buy and sell options. Nelson, a retired real estate agent, said she decided to take matters into her own hands because the broker she had entrusted with her life savings of some $250,000 had managed it down to $175,000.

“It was devastating to see my savings washed away,” she said. “I couldn’t sleep; I thought I might have to go back to work. I didn’t know what in the world I was going to do.”

Through a friend, she discovered options.

In addition to selling calls, another important option strategy involves buying protective puts on stocks. While that might sound complicated, the fact is most people already use protective puts and don’t even know it.

Paying a premium for car insurance with a deductible is essentially a protective put. And just as people buy car, health and home insurance, they can buy insurance for their stocks by purchasing a put for every 100 shares they already own.

A put gives the owner the right to sell the underlying stock at a certain price up to the exercise date.

Let’s say an investor owns 100 shares of a stock that has moved from $30 to $50.

The investor wants to continue owning the stock but doesn’t want to wake up one day with it trading at $20. A six-month put with a strike price of $50 can be purchased for $2.25, or $225 for one contract, which could be considered an insurance premium.

If the stock drops, say, to $40, the owner of the put still has the right to sell at $50 and limit the loss. If the stock remains above $50 after six months, the investor simply buys another put.

“You wouldn’t buy a car in Dallas and drive it off the lot without insurance, so don’t drive your stock off the lot without insurance,” the CBOE’s Kearney said.