If you don't have to buy options, don't do it. Options typically are an act of desperation. In the times I have been addicted to options, an optionholic so to speak, I never did well.
Once, because I had no money, I viewed options as a form of credit. That's a real sucker's game. When you consider the costs of execution, the spreads, and the gun-to-your-head mentality, go to a loan shark get a loan with 17% interest and buy common.
The second time was because my wife didn't like the market. So I played it in calls because she wasn't in charge of that portion of our trading. Soon my whole portfolio was options, as options tend to spread like Captain Trips in
(Not a King fan? That was the name of the virus that spread through the world, killing 99.4% of everybody).
Again, I lost nearly everything, because options are not a tactical weapon, to be used out in the field every day, like so many M-16s. Options should be used strategically, when you have conviction, as a way to augment, or leverage, a common stock position.
Okay, now I have scared you. And you should be scared. But let me tell you when they do work. Here's a classic situation. You have gone to hear a presentation for
. You are absolutely blown away. You think that Wall Street is dead wrong about the equity, that it is dreadfully mispriced and that the stock could go up 30 to 40 points in the next six months.
You have limited capital and IBM is a 102 stock. If you bought 50 shares you would be out some $5,100. The stock goes up your 40 points: you make $2000. Not a lot to show for that clairvoyance.
Now, instead, you chose to buy 3 IBM January 90 calls for $16.50. Okay, you have $4 a share in what is known as premium. Since each call represents 100 shares, that's a $1,200 premium. Premium, of course, is bad, as it is the toll that you must pay to get in the game. After commissions you are using basically the same amount of money. But look what happens this time: IBM goes up 40 and you make $10,800 (you lose the premium, which is why you don't make $12,000). That's a great rate of return.
I would do that trade provided (a) I was willing to lose my whole investment if IBM went down 12 points (remember, if IBM common goes down 12 and you are long the common, it's bad, but not suicidal); (b) I had other money so my only asset in the world was not a 3 call IBM position.
Let's go over again one more time why, other than the staggering return, this use of calls seems okay. The sheer dollar amount of the stock precludes you from getting the hit that I, as an institutional player can get -- we are not deterred by dollar amount at all. So calls level the playing field at a cost of a possible huge loss if the stock takes a dip and a loss of the premium if the stock does absolutely nothing after four months.
Of course, if nothing happens, come the third week of January you have a difficult decision to make, whether to sell or roll over. We will address that in a forthcoming piece about when I like to sell versus when I like to hold.
James J. Cramer is manager of a hedge fund and co-chairman of
. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Mr. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he welcomes your feedback, emailed to