Be an Options Investor, Not an Options Trader

The technical definition of a derivative is "a security whose value is derived from the value of some underlying security." That covers a broad reach of investments, and you could even argue that a stock is just a derivative of the underlying value of the company. In practice, the term "derivative" describes a massive and ever-growing universe of securities, including equity index options, cocoa futures, collateralized debt obligations, and credit default swaps.

All of that said, derivatives are just tools, and like any tool, they can be used in many ways to achieve many different objectives. The risk depends entirely on what kind of derivative is used, and how it is used--e.g., to take risks on extremely levered, highly volatile commodities or for risk reduction, hedging, or income generation. The upshot is, used correctly, derivatives can be tremendously flexible tools.

Focus on the Fundamentals
If you're new to derivatives, you may want to start by tackling equity options, which are commonly available to retail investors. Just as there are many different ways to use derivatives, there is an endless supply of hawkers selling "technical" analysis (charting) for "trading" options, and many ads talk about trading in an attempt to invoke visions of the glory days: swashbuckling open-outcry option market makers who spent their days yelling out buy and sell orders and who swaggered out and bought a Ferrari after a big winning session.

Those traders did exist, once upon a time; however, they were primarily making money on the spread between the bid and ask price, not making directional or volatility investments. They made money regardless of the direction of the stock, and had an occasional windfall as well because they could see big moves in the option trading pits and "get in front of" the momentum. Unless you are a market maker, you won't be making that bid-ask spread, and those spreads have been narrowing anyway. Most trading is now computerized, so the open outcry pits are a thing of the past. In short, you won't be making money as a "trader" the way those guys did, and neither will they.

Instead of trading, options investors should focus on bringing the rigor associated with fundamental stock research to the options market. Think of an option as a calculated investment in a company, and the volatility on that company. You may have to "make a trade" to make an investment, but those who focus on investing through options can turn the odds in their favor.

I once heard a definition that distinguishes between investing and gambling. If your expected return is positive, it's investing. If it's negative, it's gambling. Think of this in terms of Las Vegas. The house always has an edge, or it doesn't allow the bet. Buying stock in a casino that owns all the games, and has that edge, is investing. Going to Las Vegas and playing the games is gambling. Whether an option investment is very risky or very conservative, you should make it only if you have an edge and understand it.

How do you get that edge? You can begin by focusing on fundamental stock research--such as that performed by independent researcher Morningstar's 100-plus equity analysts--to identify the best option opportunities. Fundamental research--that based on the actual underlying business and its prospects--gives you an edge in understanding not only the stocks on those same companies, but also the options on the stocks on those companies. Having a sense of a company's fair value and a comprehension of the potential range of outcomes for the stock price are extremely valuable for understanding the potential investments in the options market.

There may be some fancy math involved in option investing, but if you stick to the same principles of truly understanding the underlying business and its stock, and trying to find a dollar selling for 50 cents, you're well on your way to being a true option investor.

For more option strategies, insights, and investing ideas, visit Morningstar's Option cover page: