Biggest Risks With Options Investing

By Motley Fool Staff Markets Fool.com

With Snap's (NYSE: SNAP) recent IPO and ensuing lofty valuation, many investors are wondering if now might be a good time to short the social media/camera company. But while options are a safer bet than shorting, they are not without risks.

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In this clip, Motley Fool Options expert JP Bennett explains some of the most important risks and complications involved with options, especially using them to short a company. Also, he explains a few critical things that investors should know before diving into options investing and where investors can look online to learn more.

A full transcript follows the video.

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This video was recorded on March 24, 2017.

Dylan Lewis: One of the reasons we started talking about options on the show is that a lot of people had been looking at Snapchat and saying, "This is a company that a lot of people are bearish on, should I short it?" And we had introduced the idea that, I'm generally against shorting because it opens you up to a ton of downside risk. And you'll see people use options as a limited-downside way to do some of the similar types of betting against a stock.

JP Bennett: Yeah, but there's no risk-free lunch. There are definitely things to consider when you're using it to make a bearish bet. In the case of Snapchat, what I would suspect in terms of the option premiums, especially for the puts, if there are a lot of bearish investors and they don't want to short, they want to play through options, those puts are going to cost a pretty penny. One example that is so crystal clear in my mind because it was one of the first instances of seeing how options can be influenced by short interest and what's happening in a stock is to go back in the early days of Tesla(NASDAQ: TSLA), when it was $15-$30. What you saw, even back then, there were a ton of people that said, "This stock is worthless, they're not going to do it." So, there was a really high short interest. Essentially, the cost to borrow, you have to pay a fee to borrow those shares to sell them on the market and short -- that was becoming pretty prohibitive, in terms of your potential return, because you're paying that fee. So, what a lot of people did it is, they shifted over into the options market, and were using options to make bearish bets against Tesla. Now, what ended up happening was, because so many people were doing that, basically, the premiums got skewed so heavily that the normal rules or things you see happening in the options market in terms of pricing just got thrown completely out of whack, and it really wasn't even that attractive to go bearish. It was actually really attractive to go long Tesla stock through options, because those puts cost so much money because it's something that everybody wanted to do. So, that's something that, you can use it to make bearish bets on companies, but if it's a really crowded trade, you also have to be very mindful, you have to be extremely mindful of how much you're paying or how much you're collecting.

Lewis: Yeah, I think the important thing to remember is, like other financial instruments, there is the intrinsic value side of things, but there's also the market sentiment that plays a role in the price that you're paying for it.

Bennett:Yeah. Options, just like with investing, they are tools that can be used to create a lot of good, but they can also be used as tool of weapons of mass destruction, and completely destroy your portfolio. But, because they are leveraged instruments, you can do an extremely short order.

Lewis: I think that might be a good segue into my next question. What are some other things people should know about options? Or, maybe some misconceptions about them? Or, before you do anything with options, please know this?

Bennett: Before you do anything with options, you really have to get a hang of the lingo, what goes into a strategy, the payoffs for particular strategies, and really what's at stake. Yes, it is investing. Yes, the underlying instrument is the stock. But, there are definitely noticeable differences, in terms of buying to open, writing contracts, the lingo, how things behave over time based on what the stock is doing. If you don't go into it having a pretty good grasp of that, you can get overwhelmed pretty quickly. Getting a good knowledge base -- for Options, the service that I work on, we have what is called Options U, Options University. We always tell members, "Go through the educational material first. Make sure you're extremely comfortable with everything. Potentially even open up a paper trading account just to get familiar with how everything works. Move extremely slowly, and make sure you're extremely comfortable with what you're doing before you do anything."

The next thing is something we've touched on a couple times. Never forget that these are leveraged instruments, in terms of, you're buying it, or potentially selling 100 shares of stock. You can think of it and go, "Man, I'm selling these puts, I'm generating $1 per share, that's 100 shares per contract, that's nice, but this stock isn't going to fall that far. These puts are way out in the money, so let me sell 15." So, instead of dealing with 100 shares, you're now dealing with 1,500. The risk there, depending on how high the stock is, currently, that's a pretty significant chunk of change that you may have to be on the hook for, because anything can and will happen in the financial markets. So, always stay humble and never get greedy. We prefer to sell options more than we buy them. We can get into why we do that a little bit more. But, because of that, like I said, we're the insurance company, we're taking the other side of that trade. And although it works out more often than not, you're generating a lot of income, and it can become pretty easy if you're not disciplined to say, "Man, the last 10 trades I did worked out great. I am a genius at this," and then you go, "I'm going to slowly increase the number of contracts I write over time," and before you know it, you're in over your head, and then maybe the market falls, or one or two of the stocks you were using options on tank. Then you're just up the creek without a paddle.

Lewis: Yeah. I think a lot about the 13 steps to investing that we have on fool.com. That's the intro to buying stocks and things like that. One of the pieces of advice early on is to buy your first stock, just buy one share. Buy a really small position, maybe just one share, and follow it for a little while and see what happens, and understand what makes stocks move, what people are looking for in that company, and then take larger and larger bites as you become more familiar. It sounds like your advice for dipping your toe into options is exactly the same.

Dylan Lewis owns shares of Tesla. JP Bennett has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.