Options Trading

Options trading is the act of buying and selling contracts known as options. An option is a type of derivative, meaning its value is derived from an underlying financial instrument, most commonly a stock. This contract gives the buyer the right, but crucially not the obligation, to buy or sell an underlying asset at a predetermined price—the strike price—on or before a specific date, known as the expiration date. For this right, the buyer pays a fee to the seller, called the premium. In essence, you're not trading the asset itself, but a contract that gives you control over it for a limited time. While it can be used for sophisticated strategies, it's most often associated with high-risk speculation on short-term price movements, a practice generally at odds with the principles of value investing.

Imagine you're interested in buying a house listed for €500,000, but you need three months to secure your financing. You could offer the seller a €5,000 non-refundable deposit in exchange for the exclusive right to buy that house for €500,000 anytime in the next three months.

• You've bought an option! The €5,000 is the premium.
• The €500,000 is the strike price.
• The three-month deadline is the expiration date.

If the neighborhood property values skyrocket to €600,000, your right to buy at €500,000 is incredibly valuable. You can exercise your option and capture that gain. If property values fall, you simply let the option expire. You're out your €5,000 deposit, but you avoided a much larger loss. Options on stocks work in a very similar way.

There are two fundamental types of options, each representing a different bet on the future.

A call option gives the holder the right to buy an asset at the strike price. You buy calls when you are bullish and believe the price of the underlying asset is going to rise significantly. If the stock price soars past the strike price, your option becomes profitable. If it stays below, your option expires worthless, and you lose the premium you paid.

A put option gives the holder the right to sell an asset at the strike price. You buy puts when you are bearish and believe the price of the underlying asset is going to fall. If the stock price plummets below the strike price, you can exercise your right to sell it at that higher, locked-in price, making a profit. If the price stays above the strike price, the option expires worthless.

While options trading can seem like a quick path to riches, value investors view it with extreme skepticism. The philosophy championed by Benjamin Graham and Warren Buffett is about buying wonderful businesses, not betting on fleeting price wiggles.

• Speculation vs. Investing: The vast majority of options trading is pure speculation. It focuses on predicting short-term price action, which is a gambler's game. True investing is about analyzing a business's intrinsic value and buying with a margin of safety.
• Leverage: The Double-Edged Sword: Options offer tremendous leverage, allowing you to control a large amount of stock with a small premium. A 10% move in the stock can lead to a 100% gain on your option. But this cuts both ways. More often than not, it leads to a 100% loss of your premium. Buffett famously called complex derivatives “financial weapons of mass destruction” for a reason.
• Time Decay: The Relentless Opponent: An option's value is composed of its intrinsic value and its time value. Every single day that passes, the time value component erodes in a process called time decay. This means you aren't just betting on if a stock will move, but that it will move by a certain amount, in the right direction, within a fixed timeframe. That is a trifecta of difficulty.

Despite the dangers, sophisticated investors sometimes use options for specific, conservative strategies that align with value principles.

• Hedging: Buying put options can act as insurance for a large portfolio. If you have a significant long-term holding in a company but fear a short-term market crash, buying puts can protect your capital from a temporary downturn without having to sell your quality shares.
• Generating Income (Selling Covered Calls): If you own at least 100 shares of a stock, you can sell a call option against it. You collect the premium as income. The risk is that if the stock price rises above the strike price, your shares will be “called away,” forcing you to sell at a price that may be lower than the current market price, thus capping your upside.
• Acquiring Stock at a Discount (Selling Cash-Secured Puts): This is perhaps the strategy most aligned with value investing. You can sell a put option on a wonderful company you want to own, at a strike price below its current trading price. You set aside the cash to buy the shares if needed.
  1. Outcome 1: The stock price stays above the strike price. The option expires, and you simply keep the premium as pure profit.
  2. Outcome 2: The stock price falls below the strike price. The option is exercised, and you are obligated to buy the shares at the strike price—a price you already determined was a great entry point for a long-term investment. You essentially get paid to wait to buy a great company at your price.

For the overwhelming majority of investors, options trading is a dangerous and unnecessary distraction. It is a zero-sum game played by professionals with complex models that account for factors like volatility and time decay. The odds are heavily stacked against the retail participant. Your time is far better spent learning to analyze businesses and identify wonderful companies trading at a fair price. The path to wealth is paved with patience and long-term investing, not with risky bets on short-term market noise. Unless you are an expert using them for highly specific and conservative goals, it's best to leave options on the table.