Know Your Options

By Daniel Kadlec

If you found out that Grandma was trading options on individual stocks, you would probably want to fire her broker. After all, the confusing world of "puts" and "calls," with its esoteric language and strategies, not to mention extreme levels of leverage, can bankrupt even accomplished speculators in a matter of days. So what on earth is Grandma doing putting on a "bull call spread"?

Buying insurance, Sonny. When used wisely, options are an effective way to hedge risk. That's one reason options volume, which has exploded in recent years, continues strong even amid this year's market turmoil. Accessibility is another factor. Now you can easily trade options online, and Yahoo just added options prices and tickers to its popular website.

Of course, most people who trade options aren't buying insurance; they're gambling. A call option grants the right to buy a stock at a preset time and price. A put option grants the right to sell at a preset time and price. These tools make it easy and cheap--and treacherous--to bet on near-term swings in a stock price. Consider: today you can buy a call option for about $600 that gives you the right to buy 100 shares of Oracle in mid-July at $85 a share. Oracle is now trading at about $81. Say the stock soars to $91, a full 6 points above the strike price. The gambler's profit is $600, or double his investment. Had he bought the stock instead of the option, his $600 would have fetched only seven shares, and the rise to $91 would have netted just $70.

You can see why options are seductive. Yet, in this example, if Oracle fails to reach $85 by mid-July, the call option will expire worthless, the entire $600 lost. That's the downside, the part that puts off sensible investors. More often than not, near-term options, even on a hot stock, expire unused.

What's the right way to use options? Say you're going to buy a house in October and will need to sell stock to raise the down payment. You could sell now and put the cash in the bank. Nothing wrong with that. But if you're banking on a depressed stock like Microsoft and think it will rebound, options can protect you against further erosion while giving you much of the potential gain.

Here's how: an October put option giving you the right to sell at $70--about where Microsoft currently trades--costs $5 a share. If the stock swoons, you still get to sell at $70. For that right you give up the next 5 points of gain but capture everything beyond that. A similar strategy can bridge you to the point at which you've held a high-flyer 12 months, qualifying for favorable capital-gains-tax treatment. "It puts a floor under your wealth," says Lee Reid, head of retail options at A.G. Edwards.

In general, use options only in tandem with stocks in your portfolio--to lock in gains and protect against events like an earnings report or a court ruling. There are exceptions, like Grandma's bull-call spread. That's a fairly conservative play in which you buy one long-term call option and sell another at a higher strike price. You lock in most of the difference--though the stock must go up, and if it goes way up, you lose the excess gain. If you've got a big portfolio, odds are there is an options strategy for you. Talk to a pro on this one. But, hey, how bad can it be if Grandma's doing it?

See time.com/personal for more on options trading. E-mail Dan at kadlec@time.com See him Tuesday on CNNfn, 12:20 p.m. E.T.