I’m not a financial professional. This is purely opinion and entertainment, not advice. Do what’s right for you, and if in doubt about what that is, then it’s important to find someone who’s legally able to tell you.
It doesn’t get much more passive than clicking a few buttons and watching cash roll in.
That’s the goal, anyhow.
Just make a few easy choices, enter a few numbers, and come back next week or next month to pick up your fat stack of cash.
If your introduction to stock options was through ads or social media, rather than more traditional finance, you’d quite reasonably think that options are some sort of magical and esoteric key to all the above.
Plenty of social media finance personalities would have you think it actually works that way. Magical enough to deliver life-changing returns on autopilot, and esoteric enough that you’d best not touch them before buying their course.
But if you’ve remained a little skeptical, then firstly, well done! Your wariness around anything “make money online” will serve you well. Secondly, you’re probably in search of an answer to whether options are all they’re cracked up to be.
In here, I’ll do my best to answer that question from the perspective of someone investing over a long time horizon and trying to avoid fickle techniques that yield mind-blowing returns one day and go to zero the next.
My perspective in brief is that options are fun for speculation but prudent and sustainable as a complement to a long-term portfolio. There is plenty of middle ground, worth addressing another time, but we’ll focus on that basic distinction for now.
Note: I sell nothing and have no affiliate deals even vaguely related to options trading. I want you to do well — hence my taking the time to share this perspective — but couldn’t care less whether you do well through options or through something altogether different. (And as we’ll see, you’ll probably want a bit of “something altogether different” in any case.)
Note: if you’re not sure exactly what options are in the first place, then start with this article for a gentle, non-technical introduction. Everything below will make more sense after that.
Why “investment” is the wrong word
As you gleaned from the title, asking whether options are a good investment isn’t the right question to ask. If your underlying question is whether they’re a reasonable and reliable way to profit, then that’s fair enough.
That’s because options are first and foremost a tool. To ask whether options are a good investment is a bit like asking whether a car is a good business or a guitar is good music. You could use a car as a pivotal part of a delivery or taxi service, and you could use a guitar to play beautiful songs. Alone, though, they’re simply tools.
Options are technically investments in the sense that you purchase and sell them — ideally after some appreciation — but it’s important to realize they only reflect the value of underlying assets. They aren’t a “piece of the pie,” only a leveraged (multiplied) reflection of a piece of the pie.
This creates all sorts of uses, like protecting yourself from a market crash or earning extra cash on “boring” stocks you already own. I do both regularly.
But in many folks’ minds — and perhaps yours — their stereotypical use is speculation. That’s as far from investing as a roulette wheel is from a savings account.
Speculation means huge but unlikely payoffs, where being right just occasionally is enough, but you’ll lose nearly everything on the other occasions. Investment means putting capital to work to build on itself slowly and steadily in hopes that it becomes a more valuable asset down the road.
Sure, you can use options to turn a pile of cash into a bigger pile of cash. But outside of rare and lucky exceptions, you can’t simply leave them alone to “do their thing” like an investment any more than a car left alone will sign up with Uber.
Options trading also demands a time investment
The other piece I linked in the intro will walk you through the general principles of options in an accessible and unintimidating way. But you’ll quickly need a grasp of technical concepts to understand what in the world you’re doing.
- “What will happen to this contract over time?”
- “How much will I make if the underlying price rises?”
- “What’s the risk-to-reward profile and probability of profit?”
- “What’s the opportunity cost of rolling my position?”
None of this is rocket science, as evidenced by the fact that I — a liberal arts major — am trading them profitably.
But what few of the flashy social media traders will disclose is how much time it takes to understand these concepts. Perhaps they don’t want to scare you aware. Others simply may not know, since they’ve arrived through luck more than through repeatable strategies.
(That, incidentally, is why I’m skeptical of any teacher who doesn’t disclose his own profit-and-loss statements. Even if year-on-year performance is the same, I’m inclined to follow someone who consistently returns 1–2%/month and ignore someone who depletes his account month after month and suddenly strikes gold.)
If you’re thinking as a long-term investor, then you’re trying to be a good steward of whatever capital you have access to. That means significant time spent studying and learning and experimenting.
Some of us don’t have that time available, or would at least prefer to put it to other uses. That’s just fine! The world certainly doesn’t need more options traders.
It’s not like it’s an easy or automatic way to get rich anyhow. Out of the millions of people who trade, plenty are lucky. Plenty are unlucky. Plenty more — probably the vast majority — do quite well but not to any spectacular degree.
Putting that time into a maxing out your career growth, starting an actual business, and/or finding undervalued investments are all excellent uses of that time. For many people, they’re better uses of that time, since they tend to yield not just cash flow, but sellable assets in the future.
Now, that’s not to say diligent options trading is a bad idea. It may well be more appealing than your career prospects, your feasible business ideas, or the dullness of hunting for undervalued investments. But the key word is “diligence,” by which I mean consistent and disciplined work over a long stretch of time.
It’s a thrill to wake up to 500% returns on a speculative long-term call I’d forgotten — and yes, it happens— but that’s in no way, shape, or form a long-term business model. And when it does happen, my own abilities aren’t the reason why.
Rather than focusing on trading in the sense of frequent short-term positions, we’re going to look at how simpler and lower-stress options techniques can wring more out of a long-term investment portfolio.
Sustainable approaches to options
If you take my word for it that:
- Options are useful tools but not inherently investments
- Using them consistently and rationally takes significant learning
…then you’re probably wondering what approaches actually make sense without practically earning another degree. How might one actually use these tools, and what about them is important to study?
Speaking as one small trader and investor to another, I see three reasonable and prudent uses for options. These are decidedly unglamorous and unexciting, but that’s the point.
All three involve just a single contract at a time, which makes risk-reward calculation easy and avoids the need to estimate how multiples contracts’ time and price sensitivity work for/against each other. (If that sentence makes your head hurt, you’re not alone!)
Do feel free to venture into higher-stakes territory if you like, but don’t pay anyone to tell you how, and don’t use money that it’d hurt to lose.
Keep in mind that I have a day job and side work and a family, and therefore no desire to spend all day monitoring positions to seize fleeting gains or avert catastrophic losses. As mentioned above, there are other uses for that time. Your own preferences may vary.
And before we dive in, I implore you never to use a strategy you don’t fully understand.
For instance, if a strategy is only on your radar because the Robinhood “Discover” screen recommended it, then I can almost guarantee you don’t understand it. That’s no knock against anybody, since this is not trivial stuff. It That is, however, a critical reality check.
With that in mind, treat the below as a jumping-off point for further reading. It is not remotely comprehensive or definitive. I’ve linked to an Investopedia article on each strategy, and from there, I highly recommend the projectoption YouTube channel for free, accessible, and thorough education.
Dividend income is close to totally passive, so high-dividend-yield stocks deserve a place in any long-term portfolio. But sometimes these companies go through long, slow periods of next to no growth. The dividends are great, but we’d still like at least a little price appreciation.
The next-best thing is to write covered calls, which is when you sell somebody a call option against blocks of 100 shares that you already own. They pay you a premium for that right, which is yours to keep no matter what happens next.
If the underlying asset remains below that price at expiration, then you’ve collected free money. If it exceeds that price at expiration, then you’ll be forced to sell the shares at exactly the contract price (regardless of the current market price).
This is best for shares you’re already OK with selling — preferably ones that have already appreciated and given you long-term capital gains. You’ll usually get the highest premiums on days when the share prices have risen.
Don’t write covered calls for a price at which you’d regret parting with the stock. You can always buy back the option if the prospect of selling makes you anxious at the last minute…but you’ll usually do so at a loss, which raises your overall cost basis for those shares and lowers your effective dividend yield. You also cut yourself off from major upswings, so it’s unwise during times of growth or expected growth.
But with those important caveats out of the way, covered calls are a great way to increase effective dividends and reduce cost basis on long-term positions.
Monetized limit orders
When you’re ready to buy shares, it’s often wise to place a limit order at whatever you consider a fair price. But it might take a little while to hit that price, so what if you could turn your patience into a little cash flow?
Enter cash-secured puts. When you write (sell) a put option, you’re collecting a premium in exchange for promising to buy somebody’s shares at the strike price. (As always with options, we’re talking in 100-share multiples.)
This mean you can effectively use put options as monetized limit orders. If the price doesn’t fall, then you can keep the premium and/or roll the put up to a higher strike price at which you’re likelier to be assigned (forced to buy).
You can also wait it out and keep collecting a modest premium until the underlying finally does reach your original “limit order” put. This can be surprisingly lucrative during long, upward trends.
Of course, you risk being assigned on something as it begins a massive decline. But that’s true of limit orders, too.
Then, once you do own the shares, you can continue writing covered calls (see above) to reduce your cost basis.
This is best for shares that you already wanted to own and are fundamentally bullish on. You’ll usually get the highest premiums on days when the share prices have fallen.
Some traders like to write very aggressive cash-secured puts, meaning the strike price is close to the market price, in hopes of being assigned soon. They then write aggressive covered calls after assignment, followed by more puts once the calls are assigned, ad infinitum.
That’s a strategy known as “the wheel,” and it’s fun to experiment with. But proceed with caution.
For one thing, it incur lots of short-term capital gains tax on positions that you might otherwise have held for years. What’s more, it forces you to time the markets in a way that doesn’t necessarily outperform buying and holding (assuming you actually wanted those shares anyhow). Running the wheel also requires volatile stocks in order to get worthwhile premiums — and those volatile stocks are exactly the kind you may not want to hold for the long haul.
An insurance policy
Crashes happen. You remember March 2020, and you may also remember 2008 and perhaps several before that. In all those cases, markets bounced back (and then some), but only after taking a large bite out of many portfolios. And while markets have always recovered, individual companies do so at very different rates, and some never do at all.
Just like our health and home and car, we can also insure our portfolios. A protective put is one of the simplest ways to do so. This is perhaps the least exciting use of options, but may also be one of the most prudent for long-term positions.
Unlike writing cash-secured puts to function as limit orders, we’re now buying puts to hedge a block of 100 shares. They’re cheaper as they get farther from the underlying current price, but that lower price means less protection against small dips. As with all insurance, price and protection have an inverse relationship, so you’ll have to weigh the situation carefully.
This is best for shares that you wouldn’t want to hold for years until they recover, and don’t mind paying a little to protect. It’s also a nice way to gain from a bear market without short-selling. You’ll usually pay the lowest premiums on days when the share prices have risen.
Buy protective puts too close to market prices, and the high premiums eat into gains during the good times. Too far below, and the put won’t gain significant value.
While I’ve talked in terms of directly hedging your shares, you can also buy puts on anything and everything else. Remember, you’re buying puts in this case — not writing them — so you cannot lose more than the premium you paid. You don’t have to own or even want to own the assets involved. Just stay out of heavy speculation, which is always tempting but seldom wise.
You might have noticed that everything described above is not so technically different from the Instagram-guru speculative trading I advise against.
But it’s light-years away in spirit.
Rather than betting the farm on wild swings, or even constructing lower-risk but mathematically complex positions, we’re simply eking incremental returns out of a well-chosen portfolio and insuring that portfolio against a crash.
The tools are the same, but the scale and mindset are wildly different.