When people think or hear about using options in their investment portfolios, they tend to think of them as risky instruments that lose their entire value, or worse, cause them to lose multiples of their value. But when used correctly, options can be a powerful tool to help enhance portfolio income, reduce overall portfolio risk, and make risk-defined bets on a stock, sector or fund.
What’s an Option
An option is a financial instrument, tied to or based on an individual stock or exchange traded fund, which gives the purchaser the right, but not the obligation, to buy or sell an underlying stock or fund. Options are unique in that they have a defined price to buy or sell the shares and a limited time to do so. If you don’t “exercise” your right to buy or sell the shares within the time limit, whatever you pay for the option expires and is lost.
Options are sold as “contracts” for 100 shares each. Remember, with options, you’re buying the right to buy or sell shares, not the shares themselves
There are two basic kinds of options: calls and puts. Let’s talk about each.
Calls and Puts
Think of calls as options to buy a stock or fund at a certain price. I liken a call to an option to buy a home at a certain price for a defined amount of time.
Let’s say that you’re interested in buying a home for $250,000 but aren’t sure that you can get the financing or whether the house is really worth the asking price. So you might offer the seller a sum of money to hold and sell you the house for $250,000 within 90 days. You might pay him a $2,500 “premium” for that option while you investigate financing or determine the true value of the home. During that time, the seller can’t offer to sell the home to anyone else.
If you can’t secure the financing, or you find out that the house is worth far less than $250,000, then you walk away having spent $2,500 for that right (but not the obligation) for 90 days to buy the home. If the true value of the home turns out to be $200,000, you just saved yourself $50,000 less the cost of the option (or $47,500). If the value of the home instead turns out to be $300,000, then the seller is still obligated to sell you the house for $250,000. In that case, you would exercise your option and you just made an unrealized profit of $47,500 ($300,000 less $250,000 less the cost of the option or $2,500).
Think of puts as an option to sell a stock or fund at a certain price. In many ways, a put is akin to an insurance policy.
Let’s say that house that you just bought for $250,000 is insured for $250,000 and then burns down for a total loss. In that event, the insurance company would pay you for your loss as you “put” the (burned down) house to them. But in order to do that, you had to pay the insurance company an annual insurance premium of say $2,000. If nothing happens to the home, that premium paid is lost forever.
A Stock Example
Let’s turn the discussion to call options on stocks.
Say that you own 100 shares of Apple common stock currently trading for $500, which you bought for $400 per share and you want to generate additional income on those shares (besides the corporate dividend). To do so, you can sell a call option giving someone the right to “call away” your shares for a per share price of $550 within 45 days. For that sale, someone might pay you $1,000 (you don’t ever know who that someone is, but there’s always a willing buyer at the option exchanges for the right price). Note that there are many prices (called strike prices) that you can choose from to decide where you want to part with your Apple shares.
In this example, if Apple shares move down or never exceed $550 per share by the time the option expires, the buyer of that option will walk away without buying the shares and will be out $1,000, but you’ll be $1,000 richer. In that case, you keep your Apple shares and then repeat the process at a new appropriate sales price. Remember, if the buyer of the option can buy shares on the open market for less than $550, she has no reason to exercise that option.
If, on the other hand, Apple shares are at $575 by expiration, you’ll have to part with your shares for a price of $550 (plus the $1,000 that you pocketed for selling the option). The buyer of the option the exercises her option and then owns the shares and any appreciation over $550. You just made $150 per share profit plus the $1,000 option premium. You can then choose to buy new shares of Apple and repeat the process at a higher option price. Note that the option buyer can call away the shares any time before they expire, but won’t do so unless the price of the shares is higher than $550.
Of course, with any option, you’re free to be the buyer of the calls to speculate on the price of any stock or fund. In the Apple example above, you could have been the buyer of the call option instead of being the seller and thereby speculate on the price of Apple appreciating.
So what about put options on a stock?
Lets continue the Apple example above. At $500 market value per share, you currently have $100 of unrealized profit per share. Now suppose you’ve become worried about a short-term decline in the overall market or in the price of Apple shares, but you don’t want to sell them yet. Just in case, you might want a short-term insurance policy in the event that Apple shares tumble. In this case, you might buy a $500 put option for $1,000 to give you the right to “put” those shares to someone else for no less than $500 each.
So if Apple shares drop to $450, you’ll still get $500 for your shares when you exercise your put and the seller of the put will be out $4,000 ($500 minus $450 times 100 shares less $1,000 premium received). However, if the shares of Apple are trading for more than $500 by the expiration of the put option, then the put expires worthless and you’re out $1,000 and the seller pockets $1,000.
Safe Ways To Use Options
By now you may have realized that selling options is a nice way to make some extra income. When you consider that most options expire worthless, it is indeed better to be the “house” selling the options rather than the “bettor” buying the options.
The above examples are greatly simplified to help you with the understanding of options. We’ve left out all the mechanics and nuances of option trading to aid in understanding.
The reason that options get such a bad rap is because most people are buyers of options rather than sellers, and they usually buy far too many of them. Since each option contract is good for 100 shares, you shouldn’t buy or sell more contracts than you would buy or sell an equivalent number of shares of stock. Some people even sell calls on stocks that they don’t own (this is allowed), not realizing that stocks can sometimes go much higher than they can imagine. So if you sell an option “naked”, to a certain extent, you’re taking nearly unlimited risk.
In our client portfolios, we may generate income by selling calls against shares we own, so we only have the risk of the stock being called away. We may also hedge our portfolios with options to take advantage of short-term volatility. We may do so by trading puts, but do so in a risk defined way to minimize our premium outlay or maximize our premium generation. In other words, we don’t take unnecessary unlimited risk bets with options and use them only in the safest ways possible.
Hopefully this post helps you to better understand how we (and you could) use options in your own investment portfolios. Of course, if you want to dabble in options, I highly recommend that you get yourself a good book on options and study it carefully before trying them out. Option investing is where a little bit of knowledge is helpful, but can also be dangerous if you’re not sure what you’re doing.
If you’d like to know more about what we do to enhance and hedge investment portfolios, please don’t hesitate to contact us or just ask any questions.