How to Think About Options Within an Investment System

How I See Options

Options are easily talked up as a get-rich-quick tool, but that’s not how I prefer to think of them anymore.

They are more like a set of risk-management tools. Used well, they can help you control your buying price, add a little cash flow, or buy insurance for your holdings. Used badly, they are just high-leverage gambling.

So options cannot be looked at in isolation. They have to be put back into your asset portfolio: what stocks you hold, how much cash you have, whether you can take delivery, and whether a loss would affect your family’s cash flow.

If you haven’t thought these questions through, no options strategy, however elegant, means anything.

A Few Basic Concepts

The most basic things about options aren’t complicated.

Call is a bullish option. Buying a call means paying a premium to buy the right to purchase a stock at an agreed price in the future.

Put is a bearish option. Buying a put means paying a premium to buy the right to sell a stock at an agreed price in the future.

Premium is the price of the option. The buyer pays it; the seller receives it.

Strike price is the price at which you can buy or sell in the future.

Expiration date matters a lot. An option is not a stock — it has a time limit. You can get the direction right but the timing wrong, and still lose money.

Time is what many beginners most easily overlook. A stock can take its time; an option may not be able to wait.

Common Uses

I like to divide options into a few easy-to-understand uses.

Buy Call: Using a Little Money to Buy Upside

Buying a call suits situations where you’re bullish on a direction but don’t want to commit too much capital directly.

The advantage is that your loss is limited — at most, you lose the premium.

The downside is that time is against you. If the stock doesn’t rise enough before expiration, the option can go to zero.

So buying a call isn’t simply “buy whenever you’re bullish.” It fits better when certainty is relatively high, there is plenty of time left, and volatility isn’t unreasonable.

Buy Put: Buying Insurance for Your Holdings

Buying a put can be understood as buying insurance for a stock.

If you hold a stock and worry about a sharp short-term drop, you can use a put for protection. The cost is the premium you pay.

The advantage is peace of mind. The downside is that the insurance isn’t cheap, and buying too much of it will also drag on your returns.

Sell Put: Waiting to Buy at a Price You Can Accept

Selling puts is a strategy I find relatively easy to understand.

If you wanted to buy a stock anyway, just not at the current price, you can sell a put at a lower strike price. If the stock falls, you may end up taking delivery; if it doesn’t fall that far, you collect the premium.

The key is this: you must genuinely be willing to buy at that price, and you must have the cash ready.

Otherwise, selling puts can easily turn from “waiting to buy at a low price” into “being forced to take delivery.”

Covered Call: Collecting a Bit of Premium While Holding Shares

A covered call means selling a call option while holding the stock.

It suits situations where you think the short-term upside is limited and want to collect a little extra premium from your holdings.

The risk is that if the stock surges, you may be exercised, sell the stock early, and miss the rise that follows.

So it is no free lunch — it just trades part of the upside for cash flow today.

Where Options Fit in a Portfolio

Options should not be the core of a family’s assets.

The real core is still things like index funds, the cash pool, bonds, gold, and mortgage management. They determine whether the family’s asset system is stable.

Options fit better in a very small layer, used for enhancement:

My attitude toward options is fairly simple now:

If you can explain the risks clearly, then consider doing it.

If you can’t clearly explain the maximum loss, the margin requirements, your ability to take delivery, and the expiration risk, don’t touch it yet.

Options aren’t there to make anyone rich overnight. They are better suited to doing a bit of risk management and cash-flow enhancement on top of an existing long-term asset allocation.