Investing With Options: A Beginner's Guide
Options are one of the more complicated facets of investing, and one of the subjects that listeners most often request us to cover on Industry Focus.
On this week's Tech episode, we're taking the dive and doing a beginner's introduction to options. Motley Fool tech analyst Dylan Lewis talks with options expert JP Bennett about what exactly options are, how they work, and a few risks investors need to keep in mind when using them.
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This video was recorded on March 24, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, March 24, and we're talking options. I'm your host, Dylan Lewis, and I'm joined in the studio by Motley Fool premium analyst JP Bennett.
JP Bennett: Thanks for having me, Dylan!
Lewis: Yeah, JP, what's up? I think this is the first time you've been on Industry Focus, right?
Bennett: It definitely is.
Lewis: For listeners who might not know JP, he works on The Motley Fool Options product with Jeff Fischer. I think it's fair to say that you're also known at HQ forhaving the wildest hairin the office.
Bennett: [laughs]I think that would be a pretty fair assessment.
Lewis: Do youwant to describe the look you're working with right now?
Bennett: Right now, it'sbleached to be pretty close to white. It's getting a little bit long in the tooth,so I need to go in for a haircut, but we're justrolling with it for right now.
Lewis: Do you get your haircuts done at HQ?
Bennett: No, I do not.I have to go work with someone who I have a lot of trust in,because when you put that much bleach in your hair,you get very close to bleaching it to the point where it falls out. If you'reoff by just a couple of minutes,you could see me with very short hair the next time.
Lewis: Listeners,if you want to check out JP's look,check out the videos we're going to post on fool.com. We always wind up breaking up our podcasts andposting them as videos and stand-alone articles. So, we'retalking about options today. Today's discussion was really aproduct of some conversations that I had withlisteners at our meetup in Austin duringSouth by Southwest.Any time we meet up with listeners orpeople who are fans of the show and The Fool,I always like to ask them, "Whatdo you like that we do? What aren't we covering enough that you're interested in?" AndI had several people, I think John and Bruce,a couple guys to give shout-outs to, who had mentioned, "We'dlove to hear more about options. It'ssomething we would love a primer on,at least an introduction to." Andit's something I don't know all that well,frankly. So, when you don't know something, youbring in someone smarter than you talk about it.
Bennett: Well,that's debatable.
Lewis: [laughs] So,today's episode, we'll do an Options 101 with Professor JP Bennett, and then we'lltalk about some of the questions that we got onTwitter,because I put out a little call to see what people werethinking and what they were curious about when it came tooptions. To kick us off, what are options?
Bennett: In a nutshell,options are what are referred to as derivative instruments. They derive their valuebased on something else. In this case, it's the underlying stock.Apple(NASDAQ: AAPL) options are going to have a value based on where the stock of Apple istrading at a given time. And althoughI think most listeners will knowthat there are a myriad of optionsstrategies with crazy names and a bunch of different options positions,it might seem like there's so much to learn. But if you boil it down, there are really only two options you can use. There's calls and there's puts. Calls benefit when a stock rises. Puts benefit when a stock falls. Andyou can either buy or sell them. So,there's really only a couple of basicsthat you just have to master,and then the world opens upand you have a myriad of possibilities, in terms ofstrategies that you can do.
Lewis: Yeah. Andyou get into that complexity whenyou start layering these different options together. So,how do they work,and what are the different elements that people need to focus on? Because,at the end of the day, these are really contracts, right?
Bennett: Yes. They'rederivative instruments, but they enable you to use leverage. Every options contractrepresents the right to control 100 shares of a given stock. One Apple call contractrepresents the right to buy 100 shares of Apple. So,they really have the potential to leverage your returns, or leverage your losses. So,when you're using strategies,you have to be mindful of that. So if you look at ahypothetical company,the stock is trading at $100, if you own a call with a strike price -- just to double back, a strike price is the price that isspecific to the option that you either buy or sell, and that's the pivot point for where the value is derived. The stock is trading at $100, you buy acall contract with a strike price of $100,that means that you have the right to buy shares at the price of $100,regardless of where the stock is trading at expiration. The stock could double and be at $200 atexpiration. You still get to buy shares for $100. So,that's where your profit comes from. If the stock is trading at $100 and you buy a call contract with the strike price of $90, then you get the right to buy those shares at $90. For every stock, there isspecific expiration dates. Within that expiration date,there are a bunch of different strike prices. It will depend based on where the stock is trading, how liquid it is, and things like that. So,you can tailor the strategy to suit your needs.
Lewis: If you'relooking at a call option, and that is,if you're going to go long, the opportunity to buy a stockat a predetermined price, what you're really looking at here is the exercise price, the duration, and then the premium that you're paying for that contract. That's the fee that you're paying for the optionality.
Bennett: If you want to get into the weedsin terms of how options are priced,there are really only a few matters that reallydetermine the price. Like you said, the strike price in relation to the stock price. Theimplied volatility -- so, a stock that really doesn't do much, it justmeanders along,the odds of it moving significantly from where it currently is ispretty low, so the premium that youjust mentioned that you will have to pay for that isn't very high. Youhave to worry about the risk-free rate -- though, incurrent environments, you really don't have to, because it doesn't havemuch of an influence. And, you have to worry about how long the option will be alive for, so to speak, because they areinstruments that have a finite life period. So, you can buy options for some stocks that expire at the end of the week. Insome cases, you can buy ones that go out up to two years. So, there arejust a few things that you really have to have a handle on to make sure.I don't really think we have time to get into the weeds in terms ofpricing and determiningwhether or not you're getting a fair price. But,there are really only a few factorsthat you have to focus in on.
Lewis: We talked about calls,do you want to talk a little bit about puts as well?
Bennett: Yep. Puts. If you think about, specifically, put writing, that'sactually one of our bread-and-butter strategies in Motley Fool Options. If you think about it, put writing, whereas calls benefit when the stock goes up, putsbenefit when the stock goes down. So, if you're bearish on a stock, you could buy puts. Butactually, what we prefer to do is sell puts. When you're selling a put, you'regoing to bring in that income. If you buy an option, you have to pay for that right to either sell shares at a given price or buy shares at a given price. When you sell an option, you're taking,essentially, the other side of that trade. So,you're being compensated for that. If you sell a call,you may have to sell sharesat the strike price. Because we don't know where the stock is going to end up, you're going to get paid apremium for essentially taking on that risk. When you sell puts, you'rebasically saying, "Maybe the stock falls below the strike price. Wedon't really know, so I'm going torequire you to pay me a premium in order for me to take on that risk from you." So,if you want to think about it,one of the best analogies is probably, you're an insurance company in this case, you don't really know what'sgoing to happen, but you can help someone in terms of protecting them from a stock falling. Inorder to protect them, toprovide that insurance,you have to be compensated. If you buy auto insurance,they don't just provide you that insurance for free,you have to pay them for them to bewilling to take on that risk. So, basically, in the case of writing puts, you find stocks that you really like, you find a strike price that you're OK with buying shares at, and youmake sure you're getting fairly compensatedin terms of the premium that you'll collect. And you basically become the insurance companyfor the person who's taking the other side of that trade.
Lewis: Andthe logic with that is,you would be buying these sharesat a price that's lower than the current market value. So, because it's a companyyou like anyway, you're willing to, say, buy it at $90 three months from now,even though it's trading at only $100.
Bennett: Yeah. Go back to Apple, it's around $140, it's like, "$135 is a great price for Apple. It's not there yet.I would buy it as soon as it hits that. But in the meantime,I'm going to collect some income by selling puts at that strike price. If it gets there, great, I'll get those shares. If not, at least I'll havegenerated some income while I'm waiting for that to happen."
Lewis: What are some of the other really common option moves that you guys use in Motley Fool Options?
Bennett: The two basics, put writing,we already touched on, and the other one that is normally a greatstrategy for beginners is covered calls. In a covered call, you already own the underlying stock. So,you own 100 shares of Apple, let's say. And you layer on top of that selling calls. So,Apple is trading around $140,you can potentially say, "Sell the $145 call." So, basically, what you're doing isincreasing the income that you're going to generate from a given position. You'regoing to get the dividend from Apple, butin addition to that, you'realso going to generate that option income. Now, the potential downfall of that is that you have to sell those shares at $145if the stock ends above itand you don't do anything. Again,little side note,there are a bunch of different things you could do as you get close to the expiration if you don't want to sell shares. But that's the biggest risk of writing covered calls. So,one of the cornerstones of that isnever write covered calls on stocks you don't want to sell,because eventually, you're going to end upin a position where the stock skyrockets, and you just sit there and you're like, "I should not have covered those shares." That extra $2 per share in income reallydoesn't offset the sting of a stock moving $15-$20 by the time expiration comes.
Lewis: Yeah. And one thing thatI think is probably worthclarifying for listeners is whenoptions get exercised. I think that might be something that'sa little bit confusing. It might be that you write puts and I take the other side of it, and I pay a premium for that. But, if the strike price doesn't wind up being somewhere that'sopportune for me to exercise it,it will just wind up expiring, and I'll eat that premium.
Bennett: Yeah. In most cases, theperson that's taking the other side of the trade is a market maker. Think about Wall Street,he's one of those guys on Wall Streetwith his computer, he's basically hedging out a bunch of positions and doing stuff like that. Inthe vast majority of cases,you have to wait until you get really close toexpiration for those options to beexercised, because an optionspremium is composed of two components. There is the intrinsic value,which is the discrepancy between the current stock price and the strike price. If you bought calls of Apple at $140 and it goes up to $145, you now have $5 ofintrinsic value becauseyou're essentially buying the stock at $5below the current market price. The other componentis the component that decaysaway over time,and that's what's referred to as time value. That is a function of some of the things wereferred to in the past. That component kind ofwithers away. So, when you're selling options, that's the component you want to go away over time. If you have bought an option,it doesn't make sense toexercise it unless therereally isn't all that much time value left.
Now,there are certain instances,like I said. For every general rule of thumb, there are thoseexceptions. There's something referred to as dividend poaching, and things like that. Butfor the vast majority of cases, unless there's no time value left on the option, thoseoptions won't be exercised. So,one of the great things,here at The Motley Fool, we're long-term investors, we like to think in the long term. Because options areinstruments that have a small lifespan, maybe three or four months,especially when you're writing puts,that's a sweet spot for where we're targeting, they can [...] on value pretty significantly over that time. You sell the put option and the stock falls, the value mayincreased by a smaller percentage in terms of dollars -- so, the stock falls $1, maybe your puts only change by $0.50. But,in terms of percentages, the move isgoing to be a lot greater. So, you can see thosefluctuating values and just think to yourself, "Oh my gosh,what did I get myself into?" But,you just have to sit pat and have that long-term, "Here'swhy I initially did the strategy, we're going to ride it out and wait and see and let that time out,"because that time value component is going tofluctuate significantly. But over time, because, say you buy an option that expires in four months -- that's worth a lot more,because a lot more can happen in four months than if you bought an option that expires five days from now. The odds of the stock moving over the course of three or four months isa lot higher than over the course of five days. So, the time value, all things equal,ceteris paribus, the option that expires in three or four months from now is going to have a lot more time value than the one that expires in five days.
Lewis: You touched on downside a little bit. One of the reasons we startedtalking about options on the show is that a lot of peoplehad been looking atSnapchatand 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 generallyagainst shortingbecause 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.
Bennett: Yeah, butthere's no risk-free lunch. There are definitely things to consider when you're using itto 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 investorsand they don't want to short,they want to play through options, those puts are going to cost apretty penny. One example that isso crystal clear in my mindbecause it was one of the first instances ofseeing how options can be influenced by short interest andwhat's happening in a stock is to go back in the early days ofTesla, when it was $15-$30. What you saw,even back then, there were a ton of people that said, "This stock isworthless, 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 toborrow 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, theyshifted 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 skewedso heavily that the normalrules or things you see happening in the options marketin terms of pricing just got throwncompletely out of whack,and it really wasn't even that attractive to go bearish. It wasactually really attractive to go long Tesla stock through options, because those puts costso 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 reallycrowded 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 theintrinsic value side of things,but there's also the market sentiment that plays a role in theprice 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 ofweapons of mass destruction, andcompletely destroy your portfolio. But,because they are leveraged instruments,you can do an extremely short order.
Lewis: I think thatmight be a good segueinto my next question. What are some other thingspeople should know about options? Or,maybe some misconceptions about them? Or,before you do anything with options, please know this?
Bennett: Before you doanything with options, you really have to get ahang of the lingo,what goes into a strategy, thepayoffs for particular strategies, and reallywhat's at stake. Yes, it is investing. Yes,the underlying instrument is the stock. But, there aredefinitely noticeable differences, in terms of buying to open, writing contracts, the lingo, how thingsbehave 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 throughthe educational material first. Make sure you're extremely comfortablewith everything. Potentially evenopen up a paper trading account just to get familiar with how everything works. Move extremely slowly, and make sure you'reextremely comfortable with what you're doing before you do anything."
The next thing issomething we've touched on a couple times. Never forget that these areleveraged instruments, in terms of, you're buying it, orpotentially selling 100 shares of stock. You can think of it and go, "Man, I'm selling these puts, I'mgenerating $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 apretty significant chunk of change that you may have to be on the hook for,because anything can and will happenin the financial markets. So, always stay humble and never get greedy. Weprefer to sell options more than we buy them. We canget 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. Andalthough it works out more often than not,you're generating a lot of income, and it canbecome 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'mgoing to slowly increase the number of contracts I write over time," andbefore 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 justup 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 andthings like that. One of the pieces of advice early on is to buy your first stock, just buy one share. Buy a reallysmall position, maybe just one share, andfollow it for a little while and see what happens, andunderstand what makes stocks move, whatpeople are looking for in that company, and then take larger and larger bitesas you become more familiar. It sounds like your advice for dipping your toe into options isexactly the same.
Bennett: Oh, yeah,definitely.
Lewis: SinceI knew we were going to be talking about options,I put out a call on Twitterto see what questions people had. JP, we talked intro stuff,and I get the sense, even having this conversation, we talked about thejargon and the terminology and how it can be kind of tough to get used to,it might be a lot to throw at listeners. Andwe do have some resources on fool.com thatpeople can check out. If you write into the show,I'm happy to send them along to you. But, let'sget over to a couple things that people shot over to us on Twitter.I think it highlights how people are thinking about it, and some of the earlyquestions that people have when it comes to investing in options. Jako asks, "Explain if/how options trading is different from gambling, please."
Bennett: Greatquestion. It's definitely something that,I believe it's kind of like a misnomer with options. People tend to think these areinstruments that people who are in the markets,who are in Wall Street, or whatever, can use tocreate a lot of wealth, butanybody else who tries to use them is going to get hosed, or, even people who use them onWall Street get into a lot of trouble. But it basically is just like with investing. With stocks, I believethe biggest advantage that individual investors have is their time horizon. You can try to day trade,but you give up a lot of that advantage, and really, it's going to hurt you over the long run. It's the same thing with options. You can create strategies, or basically try and trade, in a way that is very similar to gambling. If you get a home run inone of your first couple strategies, you're really set, but otherwise you're going to end up with no money. Or,you can do what we do. In Options, we targetconsistent winners,basically creating adiversified portfolio of options strategies to generate income andlong-term capital gains, and do it in a much safer, low-risk manner. Basically, we do that in terms of how we structure our trades,what types of trades we favor,the strike prices we use,expiration dates,how much we pay. If you basically go --I'm just looking at it right now -- ourupdated accuracy list forall of our close positions, we have co-advisors Jeff Fischer and Jim Gillies. For Jeff Fischer,he has a 94.6% success ratein terms of all of those strategiesfinish generating positive returns. For Jim Gillies, it's 87.9%. So, more often than not, we'remaking money on an options strategy. If you know a casino where you can go to where you can gamble andachieve those success rates, please fill me in,because I would love to go there and make a lot of money and retire early.
Lewis: That's anexcellent point. The house has a much steeper advantage when it comes to gambling.
Bennett: I wouldalso add --what you said just triggered it for me -- basically, with options,you can set it up so that you are betting against the house or that you are the house. Welike to set it up so that we are the house, so we are winning more than we're losing.
Lewis: It's alwaysbetter to be the house. We also got a couple questions from Patrick. "Inwhat situation, if ever,would you have a call option and a put option on the same stock?" Thismight be more of an advanced option concept that we're going to touch on here?
Bennett: There are straddles, there'sstrangles, there's a bunch of different strategies --
Lewis: More of that jargon.[laughs]
Bennett: -- iron condors, there'sa bunch of different strategies that could utilize that. Basically, thinking about those strategies,if you're buying them,you probably want to have the stock movesignificantly. If you think about a straddleor strangle,you're basically using puts and calls that arerelatively close together -- they're either the same strike price, or maybe they'reoff by $5. Sowhat you want to happen is, if you're long those, you want the stock to move really sharply in either direction so that one is going to end up worthless but the other is going to end up with a lot of money. So,you go into earnings, you buy the puts, you buy the calls, the stock spikes hard, the puts end up worthless because they're out of the money, but thecalls end up with a lot of value,so you make a lot of money that way. Or, you can do the opposite. A strategy that we've used, I think we have one or two that are currently active, and we actually have one that is active on the other service I work for, Motley Fool Pro. Basically, what it'sreferred to is a covered straddle. Basically,what you're doing there isinstead of buying those options andhoping or praying that the stock is going to move a ton,basically, we have stocks that we think arerelatively steady, so we're looking to double our income. We own those shares, we own 100 shares, and then we'realso setting up a covered call byselling calls against that, butwe're also selling puts. We're also saying, "We'dlike to buy more shares if it falls; if not, we'regoing to generate extra income." So, that can be an example of,potentially, a higher success rate strategy,in my opinion.
Lewis: The thought there is, you're betting that it's going to stay within a pretty tight band over the courseof the contracts.
Bennett: Yes. Andif it moves sharply in either direction, we're OK with that.
Lewis: Another question Patrick had, "Are theredifferent fundamentals to look at whenconsidering buying a long option versus buying a stock? Or, maybe,when should I buy both?"
Bennett: This tees upone of the cornerstones of how we invest using options. We basically repeat it until we're blue in the facewhenever we have live chats and meet membersthat are considering joining Options orsomething along those lines. We are investors first, and we look at thebusinesses, we study the businesses, we come up with what we think the stock is worth, ourestimate of what the intrinsic value of the underlying stock is. Andonly after we have a stock that we really like, we feel comfortable withunderstanding what the future holds for the business and what the value of the stock is, then do we look to see if the options market isproviding us with a strategythat we can utilize. We don't let the tail wag the dog in terms of, "Those puts look really good, I'm going to look at the stock, but my mind is already made up. Thecompany could be completely garbage, but those puts pay so good,I'm just going to write them anyway,fingers crossed." Wenever do that. It's always, business first, options strategy second. That's basically, the reader there is hitting the nail on the head is look at the business, findbusinesses and stocks that you like. Then look to see if you have an options strategy.
Lewis: He gets at,in the second half of that, "Whenshould I do both?"You were talking about several strategies before where you own the stock, and then you're also, possibly, buying long options, or usinginstruments based on where you think the stock price might be goingin the next couple months or years.
Bennett: Yeah. If you're really bullish on a stock,you can basically set up options strategiesthat have leverage upside. Going back to a strategy that is still ongoing but prettyclose to being set in stone is,we have what's referred to as a bull call spread on Apple. We set it up last year, when we were having the market sell off andeverybody was panicking. Basically, we bought calls that strike at $85, and we sold calls that strike at $90. There's a$5 increment there, which means the max payout is $5. If the stock ends above $90, the calls that you own at $85 end up being worth $5 more than the calls that you sold. So,that's what you're going to make. And we basically paid a little bit under $2.50 for that right. So,basically, there's an opportunity to double your moneyas long as the stock finishes above $90. And with the stock at $140, even though you would have done really well if you'd just bought shares, the return thatwe were able to generate using that strategy isobviously much higher.
Lewis: Andthat's where leverage comes into play.
Bennett: Bingo.
Lewis: Thelast question that Patrick had was, "I'mnear the expiration of the option. Do I think about itdifferently if it's in the money versus out of the money?" This issomething we touched on a little bitin the first half of the show.
Bennett: Yeah. Whenyou get close to expiration,depending on the strategyand what your plans are going for,you do have to think about it a little bit differently. When we set upstrategies like I referred to earlier, we just let them mature and see what happens in the market. But then,when you get close to expiration, if it'sout of the money or in the moneyand what you need to do will, again,depend on the strategy and what's likely to happen over that couple of days. So, let's say you wrote puts and they end up out of the money, and you getclose to expiration. You don't have to do anything. They'regoing to end without any value, so your best bet there, or, yourappropriate course of action to minimize transaction cost and things like that is to do nothing,because after expiration Friday, yourbroker is going to come in and wipe thoseobligations from your account, and you're free to write more puts in the following day. If they're in the money and you want to take shares, don't do anything, your broker willautomatically put those shares into your account and take out the cash needed to buy those shares.
On the flip side, if you have covered calls, if they're out of the money, don't do anything, they're going to expire worthless. If you're in the money and you want to sell shares, don't do anything, yourbroker is going to do it for you automatically. The differences come into play when you don't want that outcome. Even though, with puts, let's say youwant to buy the shares at that given strike price,there could be instances whereyou want to do what is referred to asrolling the contracts. So, you'llbuy back the contracts that you sold inthe past, and you'll sell new ones. Maybe you sold April contracts. You can buy those back as you get close to expiration, and write ones for July orsomething along those lines. Same thing with calls. Basically,the nuts and bolts of it --and I did a lot oframbling there -- is that itdepends. More often than not,when you're asking a basic question with options,that's the appropriate answer. It's a lot easierwhen you have specific strategies and things like thatto go through what you need to think about and do.
Lewis: Butif you're working with some ofthe simple options strategies, thenmore often than not, thebroker is going to automatically handle thingsin the background for you.
Bennett: There arecertain instances where you're doing something that, justbecause of technicalities,the broker won't recognize,so you have to either call them up or take action ahead of time. But as long as the option is $0.01 in the money,the broker is going to automaticallyexercise it for you. Unless,if you have call contracts and they're worth one penny,you can call them up and say, "Dude,don't do it for me, it's not worth it." Otherwise, they're justgoing to do it. Whether or not you want that to happen is an entirely different matter.
Lewis: Oneother thing I think isprobably worth touching on withoptions and your brokerage is, this is something you need to opt into and apply to withpretty much allbrokerages. If this conversation is something that piqued yourinterest and you want to learn more, please read up first. But if you want to go aboutpossibly trading options down the road,it's not as simple as logging into your brokerage and going to the options center and making things happen, right?
Bennett: Right. Again,this gets back to something we touched onmultiple times. These are instruments that have leverage. The broker, because of self-interest,they just don't want to let anyone trade options. Andalso because of rules and laws and things like that. But,if you don't have the knowledge,you can do a lot of harm really quickly, and not really even understand it. So,basically, yeah, there is an application process that you have to go through. Nine times out of ten,depending on your broker,it's relatively basic and straightforward. Basically,what they're trying to get a feel for is,have you traded options before,how much do you know about options,how big is your account? If your account is really small, the damage that you can do isexponentially larger thansomeone who has a much larger account than you. Basically,after they get a feel for those types of things,there are different permission levels. I think it's foolish that thereisn't a standardized permission levelhierarchy. Some have levels one through three, some have zero through four, some have one through four. Basically, the higher up you go, the more permission you have. Level one, you're looking at stuff like covered calls, because there isn't a whole lot of damage you can do there. You can't write more calls than shares you already own. If the stock falls, you already own the stock, so there'snot much damage there. You're not on the hook to buy shares,and you don't have the cash. But,the higher up in the permissions that you get, the morestrategies you can get,and also, the more danger you can get yourself into. So, beforethey give you those keys,they want to be comfortable that you're not going to,in the first month ofreceiving permission, go out and basically blow up your account and make them have to close it.
But, one important thing to remember is, weoften see this with members who join Options, is some brokers have our favorite strategiesa little bit higher up on the hierarchy,and some members are frustrated, because they can only follow some of our recommendations, and they want to follow all of them. Thatprobably isn't the best thing to doif you're just getting started. But,the thing to keep in mind here is,you can always go back and apply for a higher permission level. If you only get level one permission, do a couple trades, demonstrate to them that you know what you're doing, and then go back and ask for a higher permission level. It'svery likely that you will receive it. There are very few cases where they won't. But, making sure that you don't get frustrated, and stick with it. Also,because there's a high learning curve,it's not the worst thing in the world, right?
Lewis: Yeah,it's something that saves you from yourself.
Bennett: Right? The wayI like to think of it is,kind of like if there's an S curve with options. You learn about the extreme basics, and it's like, "There's only two options, you can only buy or sell, that's easy." And then you start studying and you realize,there's a lot here, and it can be pretty quick to getoverwhelming. But if you stick with it, there's just this point where it clicks. And once you get a couple basic concepts down pat,the rest of it is smooth sailing.
Lewis: Anything elsebefore I let you go, JP?I know we already threw a lot at listeners. We probably might be setting ourselves up for a follow-up show at some point down the road.
Bennett: I think that would be great, ifmembers have a lot of good questions and stuff like that. Should I give a plug to Motley Fool Options, to join our service?
Lewis: [laughs] I got you to talk about options forhalf an hour, I think you deserve the chance to plug that.
Bennett: Go back, 94.6% and 87.9% for closed positions, that's apretty good accuracy rating. But I would also encouragelisteners, if you're interested in it, learn more. It really doesopen up a wealth of possibilities,in terms of generating extra income,which is great in this low-yield environment,putting up strategies that canbenefit from upside to amuch greater extent than the stock itself,maybe protect you in terms of,you can set up market hedges and things like that. There are a myriad of possibilities, and if utilized correctly, options are a greatinstrument to enhance your portfolio. But then,to go back, the closing point is that, for most investors, for a large percentage of investors, the options shouldonly ever be a complement to a core long stock portfolio, because buying shares of great stocks and holding them for a really long time, that is not only tax beneficial,because you're deferring those taxes until you sell those shares, but it's really a way to generate most of your wealth, because these strategies are expiring at a much faster clip, so you're paying short-term capital gains. Andeven if you're paying long-term capital gains, the furthest you can delay them is two years. So, options can be fun, they can be cool, they can beenticing, alluring, use whatever word you want.
Lewis: They're sexy.
Bennett: Yeah, they're sexy. But,never forget to buy shares of great companies.
Lewis: I think that's a great thing to end on there. Well, listeners,that does it for this episode of Industry Focus. If you have any questions or you just want to reach out and say, "Hey," shoot us an email. You can always shoot us questions over at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. If you want to check out more of our stuff, head over to iTunes, and the whole cast of shows that we have from the Fool is there at fool.com/podcasts as well, if you want to check us out. As always, people on the programmay own companies discussed on the show,and The Motley Fool may have formal recommendations for oragainst stocks mentioned,so don't buy or sellanything based solely on what you hear. For JP Bennett, I'm Dylan Lewis, thanks for listening and Fool on!
Dylan Lewis owns shares of Apple and Tesla. JP Bennett owns shares of Apple and Twitter. JP Bennett has the following options: short April 2017 $21 calls on Twitter and short January 2018 $115 puts on Apple. The Motley Fool owns shares of and recommends Apple, Tesla, and Twitter. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool has a disclosure policy.