Rule Breaker Mailbag: How Do Fools Feel About Long-Term Options?

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In this segment from the Rule Breaker Investing podcast, David Gardner calls on the services of Jeff Fischer of Motley Fool Pro and Options to discuss an options-related investing conundrum: Is putting a small percentage of your portfolio in long-term call options on stocks you love a reasonable move? And if so, how should one do it?

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A full transcript follows the video.

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This video was recorded on Nov. 29, 2017.

David Gardner: Mailbag Item No. 7: Lucky seven, and I'm lucky to have The Motley Fool's own Jeff Fischer here, to answer a question that relates to options. Jeff, how are you doing?

Jeff Fischer: Great! How are you?

Gardner: I'm doing really well, in part because you're here in the studio. One of my best friends, here, at The Fool. We've worked together for so long. You're helping me once again today by coming in and answering this Mailbag item. It's great to see you!

Fischer: It's a pleasure! Thank you, David!

Gardner: This comes from Eric Potter, and Eric simply writes, "At our RBIPodcast, am I foolish or Foolish to devote a small percentage of my small portfolio to buying long-term call options on stocks I love, long term defined as 12-plus months. Long-term call options on stocks I love."

Now Jeff, I already know that you have a good answer, but before you do that, can you define, for somebody who's just listening to this podcast for the first time what we are even talking about? Call options? What is that?

Fischer: Yes, I can try. I can do it. Not try -- do! A call option...

Gardner: There is no try!

Fischer: It was worth it just for that! That's a good Yoda, and appropriately timed, although I don't know if Yoda will be in The Last Jedi.

Gardner: Don't you think that Yoda...

Fischer: He has to make an appearance.

Gardner: ... appears in every movie since Yoda first appeared in a movie. He's got to be there.

Fischer: He has to. So, in the spirit of Yoda, let's do this. A call option gives its owner the right to buy the underlying stock at a set price, called the strike price, by a set date, which is the option's expiration date.

Gardner: In the future.

Fischer: In the future. The benefits of a call option include that it will cost a fraction of the share price, and it will represent 100 shares of the stock. So if you wanted 100-share exposure to a company and for some reason Square (NYSE: SQ) comes to mind...

Gardner: Awesome. We love real examples.

Fischer: ... right now that would cost about more than $4,000 for 100 shares. Instead, you could buy a single call option for, just for example say, $500 and have exposure to 100 shares. It lets you leverage your money. It lets you take your money further. You profit in the call option as the stock rises and you lose as the stock falls...

Gardner: Rises, hits, and then rises above its strike price.

Fischer: Exactly.

Gardner: For example, it could rise, but if it's at $40, and the strike price is $55, and it's at $52, it's up, but you've lost everything.

Fischer: That's right. That's a really important distinction which feeds into our answer, as well to Eric's question which is, it is Foolish, I believe, to use some options in your portfolio if you want to and if you do so in a sensible way. And sensible, as we define it in Motley Fool Options -- the service now almost nine years old -- is to buy a call option that is typically in the money. If Square is a $42 stock, you'll buy a $30 or a $35 call so that you don't pay much extra value for that call option. You're paying intrinsic value. And then, David, you're already in the green.

Gardner: Where the stock's already above its strike price, it's in the money, and you're buying it then.

Fischer: Exactly. And so, in this example, if Square rises, say, 20%-25%, your call option, in most cases, would rise 70%-100%. You're putting leverage into your returns.

So as to the percentage of your portfolio, we don't really think of it that way. Options complement your long-term stocks. We want you to keep your stocks for the long term -- we all know why -- and use options on the side or as a sidecar in cases where you want the tools or the advantages that options provide you, which include leverage, risking less capital, getting exposure to more shares; all those things that can make your portfolio go a bit further.

Or, if you're not quite ready to buy 100 shares of a stock but you want the exposure, you will put $500 into Square and watch it for a few years before you commit to buying the stock. That's another way to use a call option.

Now, as for long term, that's the only we do it in Motley Fool Options. The longest term-dated option, when it's issued, has about a two-and-a-half-year life span. Right now, the January 2020 options are rolling out. Have been rolling out.

Gardner: Thirty months hence.

Fischer: Exactly. You can buy those, right now, and set yourself up for a pretty good amount of time, David. Two and a half years, almost. Not quite long term by our definitions, but getting there. And then the good news is, too, you can close that option at the end of its term and buy a brand new one that goes another two-and-a-half years forward. So, in this way, as we do in Motley Fool Options, you can have very long-term exposure to a stock. You can continue it for a decade or more if you want to.

Gardner: I wish we could talk more, Jeff, but this is already going to be a long podcast this week. That was a delight. Thank you very much for sharing that perspective and helping out Eric Potter. Thanks for writing in, Eric, and if we want to have more options from time to time on Rule Breaker Investing, my listeners just have to ask more questions on the podcast. But in the meantime, Jeff, I really enjoy hearing you on Motley Fool Money, Market Foolery, and some of our other podcasts. Thank you very much for joining us this week!

Fischer: Thank you, David!

Jeff Fischer owns shares of Square. The Motley Fool owns shares of Square. The Motley Fool has a disclosure policy.