Be an options investor, not an options trader.
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By Philip Guziec, CFA | 09-10-07 | 06:00 AM | Email Article

The mere mention of the word "derivatives" conjures a mixture of fear and confusion among most conservative investors. Discussing my new role as a Derivatives Strategist with Morningstar customers, I've learned that a typical investor's only exposure to the term "derivative" is in the context of a press story about financial catastrophe. The most common response is, "Derivatives, aren't they risky?" In truth, the only appropriate answer to that question is, "It depends."

Philip Guziec, CFA, is a strategist on the alternative funds research team for Morningstar.

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. But we hope to make you comfortable with derivatives as tremendously flexible tools. Their use varies greatly, from taking risks on extremely levered, highly volatile commodities to risk reduction, hedging, or income generation.

We've chosen to wade into derivatives research by tackling equity options, which are commonly available to retail investors. Our objective is to make options approachable. To that end, we will:

Explain options in plain English
Longtime users of Morningstar's research are quite familiar with the matter-of-fact, plain-language style that Morningstar analysts use in  their reports. We'll be using the same style in our options research.

Emphasize options investing rather than trading
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, I'll be focusing on options investing by bringing the rigor associated with Morningstar stock research to the options market. I'll be discussing calculated investments in companies, and the volatility on those companies, through options. You may have to "make a trade" to make an investment, but we'll be investing through options, not just trading them.

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. Some options investments may be very risky, but we'll make those investments only if we have an edge and understand it--we'll be doing options investing, not options gambling.

Distill the volumes of options data into intuitive concepts
To the uninitiated, options data can look like a bunch of messy numbers. Even viewing a single options chain (a list of price quotes) can be overwhelming to the new options investor. Options are also known for complex math. In fact, the use of Greek letters is common, making many investors feel "It's all Greek to me." But we're going to do the dirty work for you by translating the complex math and massive data streams into far more intuitive images. At Morningstar, we've been finding graphical, intuitive solutions to present complex data on mutual funds, stocks, and other investments for years. We plan to bring everything we've learned to make options investing just as comprehensible and useful, whether you're new to derivatives, or a more experienced investor.

Use our fundamental stock research to identify the best option opportunities
There are over 100 equity analysts at Morningstar covering about 2,000 companies. We think our analysts' fundamental research into these firms gives us an edge in understanding not only the stocks on those same companies, but also the options on the stocks on those companies. In fact, our analysts' understanding of a company's fair value and their richer comprehension of the potential range of outcomes are even more valuable for understanding the potential investments in the options market than they are in the stock market. By combining that with a firm grasp on the underpinnings of options theory, we hope to identify some great opportunities. You can think of Morningstar's options research as fundamental stock investing--with some fancy math tacked on at the end.

Develop tools and methodologies to integrate derivatives into investor portfolios for return enhancement and risk reduction
Investing through options isn't as straightforward as buying great companies at great prices and holding them. Options expire, introducing timing into the equation, and many different risk levels and payoff scenarios can be structured by using different options on a single company. We'll be tackling these issues systematically, and developing a total portfolio approach to options investing, including a clear understanding of the potential risks of different strategies. For the risk averse, we'll help to develop an understanding of how to use options to protect a stock portfolio from disaster.

Overall, we're putting together all of our existing knowledge and research to build an intuitive options resource and bring a fresh, fundamental investor's perspective to the options marketplace. There may be some fancy math involved, and we may be developing and adjusting our methodologies as we go along, but we'll stick to the same principles of trying to find a dollar selling for 50 cents, and we'll be calling out options investing opportunities as we find them.

Morningstar's Guide to Equity Option Investing
by Philip Guziec, CFA, Derivatives Strategist
The tumultuous market has prompted many investors to ask about using options to hedge stock portfolios. At the same time, people are concerned about whether options are too complex to use as an investment tool. Our free, 40-page manual will help you execute smart option strategies the Morningstar way.

Click here to download your copy today.

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Philip Guziec, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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