How Options Can Lower Your Investment Risk

I know… you’ve probably heard that trading options is risky and difficult. Let me dispel that myth right now. When approached correctly, trading options provides less risk and more return on investment than trading stocks.

Options are financial instruments that derive their value from another underlying asset or financial measure. Options come in two forms, calls and puts, adding them to your current investing and trading tools allows you to benefit from both bullish and bearish moves in either underlying asset you select. You can do this to limit your total assets at risk or to protect an existing position.

So, take a deep breath. I’m going to try to make this easy.

Basically, options are “contracts” to buy or sell 100 share blocks of an underlying stock. An option contract allows one the right (but not the obligation) to buy or sell 100 shares of a particular stock at a defined price by a defined date. A call option allows one the right to buy a 100 share block of a specific stock by a specific date, and a put option allows one the right to sell a 100 share block of a specific stock by a specific date.

Some people have a hard time wrapping their heads around what an option is. Even if they have some knowledge of options, most don’t know how to trade them profitably.

Okay, for starters, from now on when you hear the phrase “stock options,” think of “contracts.” They are called “options” because the owner has the option to exercise it, or not.

There are two kinds of options – “call” options and “put” options, or calls and puts for short.

Call options give the buyer of the option the right—but not the obligation—to buy an asset at an agreed-upon price at a given time in the future.

Put options give the buyer of the option the right—but not the obligation—to sell an asset at an agreed-upon price at a given time in the future.

Why use options? Let’s walk through an analogy to illustrate some reasons why someone would want to enter into an option contract.

A Call Option Analogy

Let’s say your job transfers you to San Francisco from Dallas. The company needs you right away, so you head west, leaving your wife and kids behind until you can find a house. In San Francisco, you find a beautiful 3-bedroom house. You email your wife a bunch of pictures, but you want her to actually see it before you buy.

So, you offer the seller $5,000 for an option to buy the house for $800,000 within 60 days. He agrees, and you have a deal. The option is transferable.

A month later your wife makes it from Texas, and she hates the house. She’s afraid of earthquakes, and falls in love with another house away from the fault line.

But the good news is that you find out that the house, being in the hot market of San Francisco, has already appreciated by 5% to 840,000. And you find someone who wants the house, so you sell him your option for $10,000.

You just made $5,000.

What just happened? Basically, for $5,000, you controlled an asset worth (originally) $800,000 with a contract.

You never actually owned the house, but you profited by buying a contract and selling it.

That’s how a call option works. The buyer of the call option (the prospective homebuyer placing a contract on the house in San Francisco) believed the price of the house would rise and wanted to reserve the purchase price of $800,000.

The seller of the call option (the home seller giving the option buyer a contract for 60 days in exchange for $5,000) was willing to sell the asset at the agreed-upon price of $800,000. Note that if the option is never exercised—that is, if 60 days pass and the holder of the call option never “calls” it, the call option seller still owns the original asset and has made $5,000.

A Put Option Analogy

Let’s use another housing example to learn about puts.

Remember, an option is a contract between two parties. The acquirer of the put option—the put buyer—is purchasing a contract that allows him to sell an asset at a given price in the future.

The seller of the put option contract is taking the other side of the trade. He is agreeing to buy an asset at a given price in the future.

It’s a little tricky, so let’s go over it one more time. The buyer of a put option gets the right, but not the obligation, to sell an asset at a given price in the future. The seller of a put option agrees to buy that asset at the given price in the future.

Now…let’s use another home-buying scenario. Say you’re familiar with a particular neighborhood and the values of the homes in it.

You see an attractive little house that you think is worth $400,000. Paying $400,000 for it would be a good deal in your opinion. But you’re not interested in a “good” deal on that house. You’re interested in a great deal.

You’d love to buy the house for $340,000, or 15% ($60,000) below the market price. You approach the owner of the house and start talking. You learn the homeowner is concerned about the economy, the upcoming elections, and negative interest rates that Europe and Japan are experiencing. He’s worried that the price of his home could sink to less than $300,000, and he even believes that the house is only worth $350,000 to begin with.

You tell the homeowner: “Well, you never know what will happen in the world. But I think I can help relieve some of your anxiety. If you give me $2,000, I’ll agree to buy your house for $340,000 if you decide you want to get it off your hands. That offer is good any time for the next 12 months, no matter what happens.”

The nervous homeowner agrees to your offer. You draw up a contract and sign it, and he gives you $2,000 cash. He has just purchased a put option. This is generally how selling a put option works. You (the put option seller) enter into a contract with the homeowner (the put option buyer) that gives the put buyer the right, but not the obligation, to “put” that house to you for $340,000 sometime in the next 12 months.

Here are two potential outcomes:

1. If housing prices continue to rise and there are no problems with the economy, the homeowner decides not to sell you the house during the 12 month period. You keep the $2,000.
2. If the homeowner decides to sell you the house within the next 12 months, you are on the hook to buy it for the agreed upon amount of $340,000. Remember, you believe the house is worth $400,000 so you are ecstatic that you can purchase it for $340,000 along with the $2,000 you receive from the seller that will bring your costs basis down to $338,000.

I hope these analogies shed some light on how using options can work in one’s favor. Now let’s stop talking about hypothetical housing purchases and instead focus on stock options and how we can use them to collect safe, sleep-at-night income.

To simplify the discussion, I am not including the cost of commissions, which can vary significantly depending on the broker you use. Keep in mind that the commission fees on selling options reduce the total premium you collect.

Putting the Odds in Your Favor

Most stock option buyers lose their money… just like most casino gamblers lose their money in Las Vegas. This is because over 90% of option contracts expire worthless. In Las Vegas, casinos occasionally have to pay out money to gamblers, but the odds are so stacked against the gamblers that casinos make billions of dollars a year. We want to trade like the House, with the odds on our side, which means selling, not buying options!

Potential Outcomes to Selling a Put

Let’s walk through some possible outcomes to selling a put in the stock market. In the second example above, the put seller is “you,” the prospective homebuyer. One day, you look at the market and see that a stock you are researching in Stock Rover has a good value relative to the company’s earnings. It is currently sitting at $20/ share, but as an astute investor you still would like to acquire the stock at a 10% discount, at the purchase price of $18/ share. You look at an option chain and decide to sell a put option that will expire 1 month from today. You sell $20 put and are able to collect a premium of $2.00/share or a total of $200 (keep in mind the money you collect is multiplied by 100 since each contract represents 100 shares).

Here is what could happen…

Outcome #1:

The stock appreciates to $25, the put is not exercised, and you miss out on the gain from $20 to $25. However you still keep the $200 you collected from selling the put option.

Outcome #2:

The stock stays at $20 (“at the money”) and goes nowhere, then your option expires. You keep the $200 that you collected from selling the put option.

Outcome #3:

The stock drops to $19 and you are assigned the position at $20. But remember, you when you sold the put option you collected $200 on the contract, thus you own the stock at $19 however you currently have a gain of $100. Let’s walk through that. You have paid $2,000 for 100 shares or $20/share for a stock currently at $19/share, but because of the $200 premium you were paid, your cost basis is actually $18/share or $1,800 for 100 shares.

Now that you are assigned this stock, you can begin selling a call, thus collecting more premium (to be discussed in my next blog post).

Outcome #4:

The stock drops to $18, and you are assigned, meaning you buy 100 shares for $20 apiece. However, remember you collected $200 in premium thus you are at a break-even (spending a total of $1,800 for 100 shares at $18/share) and you are happy because you are now purchasing the stock at the 10% discount that you originally wanted. If you originally had just purchased the stock at 20, you would be at a loss of $200.

Now that you own this stock, you can begin selling a call, thus collecting more premium (to be discussed in my next blog post).

Outcome #5:

The stock drops to $16 (a 20% rare drop in the stock), you are assigned. However, remember you collected $200 in premium, thus you are at a $200 loss. If you originally just purchased the stock at $20 and did not sell a put to collect $200 from the premium, you would be at a loss of $400. You still believe in the strength in the stock.

Now that you are assigned this stock, you can begin selling a call thus collecting more premium (to be discussed in my next blog post). Or, you could sell another put, collect more premium, and lower your cost basis. Again, this is where it is important to make sure you are adhering to your strict money management rules. You noticed this stock just had the largest 1-month drop price in the past three years and you have never seen the stock drop more than 10% in one month. You also see the stock is offering you a bargain purchase price based on your research of the company. Because of this, you stick to your guns and sell more puts to bring down your cost basis and hopefully acquire more shares. Worst case, you still collect the premium.

Let’s discuss the negatives; perhaps you no longer want to hold the stock. You sell it at a loss of $200 ($20/share -16/share price drop + premium of $2/share you collected from selling the put option). Now, if you originally purchased the stock at $20/share and it dropped to $16/share you would have lost $400.

As shown above, you are winning 4 out of 5 times, versus if you traditionally would have purchased the stock, you would have only won if outcome #1 happened. This is assuming that you otherwise would have purchased the stock at its $20 price, not foreseeing a discount.

A Real Life Example

Let’s assume I researched a stock within Stock Rover and I came up with a stock that I would like to purchase. After conducting due-diligence, let’s say I feel that Sarepta Therapeutics Inc. (SRPT) stock is at a good price, however I would still like to purchase the stock at a discount like Warren Buffett. (Please note, I pulled this stock at random, I am not actually recommending you trade it.)

So I look at the option chain in Yahoo Finance and sell a March 24 put (traditionally, option contracts expire on the third Friday of every month, however there are now also option contracts that expire weekly) on this stock at a strike price of $14 and am able to collect the mid-price spread between the bid price of $1.00 and ask price of $2.05. The price I am going to sell this March 24 put option is at $1.53—the mid-price between the bid and ask. (Note that on more heavily traded options, the spread between the bid and the ask tends to be much lower.) Thus, I am collecting $153 per contract (each contract representing 100 shares) if the stock does not move anywhere by March 24. If the stock goes up, I keep the premium. If the stock goes down from its current price of $14.29 to $12.47 by March 24 when the options expire I will be assigned the stock at a purchase price of $14/share. Lucky for me, I also collected $1.53/share (or $153) by selling this put thus I have not lost any money at all, I am at a break-even price. Now that I am assigned this stock at a great price, I continue my money management techniques and I hold the stock for upward appreciation and now I am in the position to sell calls.

The stocks I primarily like to sell puts on and own are blue chip, strong dividend stocks because I can collect premium by selling puts and selling calls, and collect dividends when I own the stock. Therefore, I am able to collect income from the stock in three ways as opposed to simply owning the stock and hoping for appreciation.

For put options, I recommend finding good quality stocks that are not volatile and that have a goodhistory of paying dividends (and of course have options). You always want to make sure that the options do not have wide spreads and that you enter your price on a limit order at the bid price when you sell a call or put to open the trade

Now let’s fast forward to March 25 and assume we now own the stock. Now that we own it, how can we continue to collect income on the stock? We sell calls. ☺

I’ll discuss selling calls on this blog next week. Until then…happy trading!

Part II: Selling Calls >

 

Randall Bal is a professional swimmer and individual investor. Read our profile of him here.