The Risks of Derivatives: Options, LEAPS, and Warrants

Options, LEAPS, and warrants are all derivatives, which means that they derive
their value from the value of some other equity.  Derivatives by
their nature use a great deal of leverage, and therefore are
extremely risky.  In particular, all of these types of assets are
wasting assets, meaning that their value declines with time.  Not
only do you need to be right, but you need to be right within a
certain amount of time.  If the stock doubles in price the day before
expiration of your options, you may make a fortune.  If it doubles
the day after, you lose the entire position.

The advantage of using such leverage is that one can use a small amount of money to control a large amount.  If one were to simply buy the shares of a stock and the price increased by 10%, one would make 10%.  If one bought the call options, however, for an equivalent amount of stock, one could make 100%, 200%, or more for the same price move.  It is this type of return that attracts many to options.

In general, however, none of these types of securities is suitable for an
investor.  Investors buy stakes in companies and hold them for long
periods of time – they don’t play short-term price swings.  If one
is looking for a little excitement and the casinos aren’t appealing,
a small amount (say 5% of a portfolio) might be used   for such
speculations.  Plan on losing the entire position, however, since
that is precisely what will often happen.

There are some valid times to use options, however.  Options were designed
to be used as insurance.  By buying a put option on a large amount of
stock, for example, one could put a floor on the price at which the
stock could be sold.  Perhaps if one thought the price was way to
high but wanted to delay the sale into the next year for tax
purposes, one might buy a put option to lock n the gain without
selling and realizing it.  Like all insurance, however, options tend
to cost money and it is more efficient to simply sell the shares to
lock in the gain.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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