Back in 1998, the head of the derivatives desk at Goldman made me read a 1,000 page book called, Options As A Strategic Investment by Lawrence McMillan after our first round of interviews.
When I came back for my next round of interviews two months later, all they asked was,”What is a butterfly spread?” from the second chapter! I got the answer right, but was annoyed that I had spent so much time on a book I’d never use again. Ever since then, I haven’t spent any time trading options myself. Instead, I just buy the occassional structured note for a fee to keep things simple for downside protection.
But for those of you who are super gung-ho about investing, here is a guest post from Dom at GenYFinanceGuy.com about the benefits of selling options.
I have always believed that risk is a function of education. The media may have you convinced that options are very risky, but what if I told you that you could actually take on less risk than buying stock outright? If you take careful steps and don’t speculate, you can increase your probability and reduce your cost basis. Oh, and you won’t be afraid of volatility again, you will actually hope and pray for it.
There are two option strategies that will allow you to buy Stocks and ETF’s below current market prices. The Covered Call and the Short Put are option strategies that allow you to go long at discounted prices every trading day of the year. The discount prices get deeper during corrections when fear drives volatility through the roof, which inflates option premiums.
Before we get into how options can be safer and more advantageous than buying stock outright, let’s get a few definitions out of the way.
OPTION TRADING DEFINITIONS
Option – An option is a derivative, which means its value is based on something other than itself (in this case the underlying asset/stock). Make a note that every option for stocks represents 100 shares.
Call Option – As a buyer, a call option gives you the right, but not the obligation to buy a stock at a certain price by a certain date in the future. You pay a premium for this right. As a seller, a call option gives you the obligation to sell a stock at a certain price by a certain date in the future, should the buyer execute his/her right. You collect a premium for this obligation.
Put Option – As a buyer, a put option gives you the right, but not the obligation to sell a stock at a certain price by a certain date in the future. You pay a premium for this right. As a seller, a put option gives you the obligation to buy a stock at a certain price by a certain date in the future, should the buyer execute his/her right. You collect a premium for this obligation.
Strike Price – The price at which a put or call option can be exercised.
Expiry – The date the option expires.
In The Money (ITM) – A call is said to be ITM when the underlying’s current market price exceeds the strike price. A put is said to be ITM when the underlying’s current market price is below the strike price.
Out of The Money (OTM) – A call is said to be OTM when the underlying’s current market price is below the strike price. A put is said to be OTM when the underlying’s current market prices is above the strike price.
At the Money (ATM) – A call (and put) is said to be ATM when the current market price is equal to the strike price.
Intrinsic Value – The intrinsic value is the difference between the underlying’s price and the strike price.
Only options that are In The Money (ITM) have intrinsic value.
Call Intrinsic Value = Underlying Current Price – Strike Price
Put Intrinsic Value = Strike Price – Underlying Current Price
Time Value (or Extrinsic Value) – The value in excess of the intrinsic value.
Time Value = Option Premium – Intrinsic Value
Margin of Safety – The amount a stock can fall from its current market price before you start losing money.
EXAMPLES OF TRADING STOCKS VERSUS OPTIONS
For this post, let’s assume that we are die-hard index investors, and in particular we love the SPY ETF (which represents the S&P 500 index).
When it comes to getting long an underlying, I want to compare 3 choices, all of which have their own tradeoffs. In these examples, we are going to assume you are investing with cash and not on margin. All examples are based on a 1 year holding period. We will also ignore commissions, for simplicity. Lastly, we will assume where applicable, that a full years’ worth of dividends is received.
Below is a screenshot of the SPY and the option prices used in this post for your reference:
Example #1 – Buy 100 shares of SPY @ $189.70 in October, 2015 (current dividend yield is 2.18%)
This is the example that I believe most people can understand intuitively. To buy 100 shares requires $18,970. With the SPY ETF, you have minimal downside protection, but unlimited upside.
Below is the graphical representation of the risk/reward for investing 100 shares. Notice the 1 year breakeven is $185.56, represented by the orange line. This is calculated by subtracting the dividend ($4.14/share) from the purchase price ($189.70/share). This also represents your theoretical risk per share because it is highly unlikely that an index fund is going to go bust and be worth ZERO. If this were to happen, it would imply that all 500 companies in the SPY went bankrupt.
The purple line represents the risk/reward continuum. Your reward is unlimited to the upside, as it can theoretically go up infinitely.
The only downside protection you have is the dividend you receive while you own the stock, which in this example is 2.18%. We will call this your margin of safety, as this is how much value the stock can lose over a 1-year period before you start losing any money.
Capital Required = $18,970 (the amount needed to initiate the position)
Potential Reward = theoretically unlimited upside (average return of 8% would be $1,517)
Downside Protection = the Dividend @ 2.18% or approximately $4.14 ($414)
1 YR Breakeven = $185.56 (Purchase Price 189.70 – Dividend 4.14)
Theoretical Risk = $18,556 (assuming you collected the full dividend)
Margin of Safety = 2.18% (185.56 divided by 189.70 minus 1)
Example #2 – Buy 1 September 2016 $190 Strike Covered Call for $175.77 (buy 100 shares @ $189.70, sell 1 call option @$13.93), with 364 days to expiry
A covered call still involves the purchase of stock, while also selling a call. It is a “covered” call because you already own the stock. When selling a call against a long stock position, I typically like to sell the ATM call or 1-2 strikes OTM (i.e. strikes above or at the current market price). These calls are going to have the most extrinsic or time value. As a seller of the call you promise to sell the stock at the strike price anytime between the time of the sale and the options expiration date.
In this example, you are selling the $190 call for a premium of $13.93, which obligates you to sell the shares at $190 to the person who bought the call if they execute (giving you an effective sales price of $203.93). Either way you get to keep the $13.93 (or $1,393).
Keep in mind it wouldn’t make any economic sense for the call buyer to execute his option unless the SPY was trading at $203.93 (his breakeven) or higher (he doesn’t start making money until the SPY exceeds $203.93).
The premium you collect from selling the call now gives you a new cost basis of $175.77 in the event you don’t end up getting exercised to sell your shares ($189.70 minus $13.93). Of course the trade-off for the reduced cost basis is capping your upside.
Let’s look at 4 ways this could play out:
1. The buyer of the call exercises his option to buy the stock from you the same day he buys the option (unlikely, but hang in there). In this case you don’t collect any dividends and you make an instant 8.1% return ($190 sales price divided by cost basis of $175.77 minus 1).
2. The buyer waits until the option expires to exercise his right to buy the stock from you. In this case you collect $4.14/share in dividends, which reduces your cost basis from $175.77 to $171.63. You have now earned a 10.7% return (190 sales price divided by cost basis of $171.63 minus 1)
3. The third scenario is that the option expires worthless, you keep the premium and your stock. Your new cost basis is $171.63 and you can do it all over again.
4. You also have the option to buy the call back at any time and keep the spread.
Capital Required = $17,577 (the amount needed to initiate the position)
Max Potential Reward = 10.7% or $1,837 [($1,393 premium + $414 dividend + $30 appreciation) divided by risk $17,163]
Downside Protection = the $18.07/share [$1,393 premium collected from selling the call, plus the $414 dividend (or $1,807)].
1 YR Breakeven = $171.63 (Purchase Price 189.70 – premium 13.93 – dividend 4.14)
Theoretical Risk = $17,163 (assumes you collected the full dividend)
Margin of Safety = 9.5% (171.63 divided by 189.70 minus 1)
Let’s look at an analogy of how selling a Call against stock would work with selling a house.
You live in the Bay Area and the market is on fire. An identical house to yours sold for $1,000,000 three months ago in your neighborhood. It was listed at $900,000 and through a bidding war went for 11% over asking. You met with your real estate agent who wants to list your house at $1,000,000 because it will likely sell for a premium. You set a goal to sell for $1,080,000.
Just as you finish placing a “For Sale” sign outside, a stranger passing by asks if you’re the owner and if the house is indeed for sale.
After you confirm, the stranger (we will call him James) explains he is in the market. He offers to pay you $20,000 up front if you are willing to hold the house for 30 days and sell it to him for $1,080,000 when he returns from his travels around the world. If you accept, you are locking in a sales price of $1,100,000 (the $1,080,000 + $20,000 fee for holding). If someone else offers you more, you can’t take it.
You agree to the offer James makes. He pays you $20,000 on the spot and now 1 of 3 scenarios are to play out:
1. James returns from his trip and exercises his option to buy the house from you at $1,080,000, you had to pass on an offer of $1,120,000 to fulfill the agreement you made with James (leaving $20,000 on the table).
2. James returns from his trip and decides not to execute his option, you keep the $20,000, and sell it to the next best offer. Your next best offer is $1,060,000 (for an effective sales price equal to $1,080,000 after you add in the $20,000 you get to keep).
3. After James decides not to execute, you find out the next best offer is at asking of $1,000,000. You decide to hold out for better prices. You just made an easy $20,000.
Example #3 – Sell 1 September 2016 $190 Strike Put for $17 (or $1,700), with 364 days to expiration
Our last example is that of selling a put. Take notice that the risk profile charts for a covered call and a short put are exactly the same shape. This is because they are synthetically the same strategy.
Like the covered call, I typically like to sell the ATM or 1-2 strikes OTM. In this case we are selling the ATM $190 put for a $17 premium or $1,700. By selling this put we are obligating ourselves to buy the stock at $190 if exercised. But after you take into consideration the premium collected, our effective long price is actually $173. Again, it doesn’t make economic sense for the put buyer to exercise his option if the stock is not trading at or below $173/share.
Let’s look at 3 ways this could play out:
1. The buyer of the put exercises his option to sell the stock to you. You keep the premium and now own the stock with an effective cost basis of $173/share. You are now free to turn this into a covered call (see above).
2. The stock finishes somewhere between $173 and $190, you buy the put back for less than you sold it for and keep the difference. You make something between 0% and 9.8%.
3. The option expires worthless, you keep the premium and you have no position left. You make a 9.8% return ($17 premium divided by effective cost basis of $173 minus 1).
Capital Required = $17,300 (the amount needed to initiate the position)
Potential Reward = 9.8% or $1,700 ($1,700 premium divided by risk $17,300)
Downside Protection = the $17/share premium collected from selling the put (or $1,700).
1 YR Breakeven = $173 (Strike Price 190 – premium 17)
Theoretical Risk = $17,300
Margin of Safety = 8.8% (173 divided by 189.70 minus 1)
Let’s look at an analogy of how selling put options would work with buying a home.
This example was taken from a newsletter called “The Palm Beach Letter.”
It’s your dream home. But it’s listed for $500,000… $100K more than you’re willing to pay. The seller isn’t interested in your offer.
So, you come up with a creative solution to keep yourself in the game… You offer to buy the house for $400,000. But to sweeten the deal for the seller, you add this carrot: The seller can accept your $400K bid at any time over the next year.
The seller likes this because it gives him time to try to find a buyer who’ll pay more for his house. It also gives him reassurance he’ll still get money from you if he can’t find another buyer.
But in exchange for this new contingency offer, the seller must give you $5,000. And you get to keep this $5,000, whether or not you end up buying his house.
Now, if the seller agrees, one of two things can happen:
1. Sometime over the next year, he’ll agree to sell you the property at your initial asking price of $400K. Maybe housing prices will fall dramatically… or he’ll need to move quickly… or he just won’t find a buyer willing to pay more. In either case, you’ll get the house for $400,000. Plus, you’ll get to keep the $5,000 (an effective cost basis of $395,000).
2. He’ll never sell you the house. Maybe he’ll find someone who’ll pay his $500,000 asking price, or he’ll decide not to sell at all. Still, you’ll get to keep the $5,000. So, while you didn’t get the property you wanted, you’ll generate an easy $5,000 in income.
WHY VOLATILITY CAN BE YOUR FRIEND
Here is a quick note on volatility.
When it comes to selling options, the higher the volatility the higher the premium you can extract from the market. More premium translates into an increased margin of safety.
Here is a quick example why volatility is your friend when selling options.
– On 8/18/2015 when the SPY was trading for $209.98, the October-2015 $200 strike PUT was $2.00 (a put that was $10 OTM) = Effective long price of $198
– On 8/24/15 when the SPY was trading for $189.55 the October-2015 $179 strike PUT was $6.38 (again $10 OTM) = Effective long price of $172.62
During large moves to the downside, fear increases, which in turns increases volatility as investors look to buy protection to decrease their losses (volatility and price have an inverse relationship).
In this real example, the SPY was almost $20 lower, but because of the explosion in volatility (fear), you were able to get 3X the premium for a put that was still only $10 OTM from the current market price. I should point out that during this move the VIX went from 13.8 to a high of 53.3 and closed at 40.7.
If this is your first exposure to options, I hope you keep an open mind about the role they can play in your portfolio. For those who have been brain washed to believe that options are dangerous, I hope this gives a view of the other side of the coin. There is a difference between using options for speculation and using them to reduce risk (and thus cost basis).
Like anything in life, there are tradeoffs when selling options. In return for the premium you collect, you are agreeing to a defined upside reward, but you also are giving yourself more than one way to win. Think about the examples we went through above. In either case you make money if the SPY goes up in value, stays the same, or if it goes down until it reaches your breakeven point. That is a pretty good trade off if you ask me.
These are the two best strategies to get long stock at below market prices. With options, every day is a sale in the market.
Are you starting to see options in a new light? Would you consider the short put or covered call in your portfolio? What other thoughts or questions do you have?
-Dominic @ Gen Y Finance Guy
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