Using Stock Options Effectively

This is a brief introduction into stock options and how they can be used by a long-term oriented investor, either to purchase shares at a discount or to generate additional income to supplement dividend payments.

A stock option is a contract between two parties to buy or sell the shares of the underlying company at some agreed price. The buyer of an option has the right to exercise the option if he chooses to, but has no obligation to do so. The seller of an option however has the obligation to take the other side of the trade if the option is exercised. This means that both parties have a very different risk and reward profile. The maximum risk for the buyer is the price of the option, while maximum reward is not capped. The opposite is true for the seller, with maximum reward being the price of the option. Since it does not make sense to exercise an option which is not profitable, the seller wins only if the option expires as worthless.

Definitions

A call option gives the right to buy shares of the underlying company while a put option gives the right to sell shares of the underlying company. Options have a strike price which is the price at which shares can be bought or sold. Options also have an expiration date by which they must be exercised. European-style options can be exercised only at expiration while American-style options can be exercised at any time before expiration. The price of the option is also called premium.

It is said that an option is in the money (ITM) when exercising it would be profitable, and out of the money (OTM) when not profitable. A call option is in-the-money when the market price of the underlying stock is above the strike price of the option. A put option is in-the-money when the market price of the underlying stock is below the strike price.

A single option generally represents 100 shares of the underlying stock.

Volatility

Implied (or expected) volatility of the underlying stock has a big impact on the price of stock options. When volatility is high, it means there are more possible outcomes for the price of the stock when the option expires. This larger uncertainty makes options more expensive. The opposite is true when implied volatility is low and options become cheaper. Therefore, as a rule of thumb, it is a good idea to be a buyer of options when volatility is low (when things feel calm in the market), and to be a seller of options when volatility is high (when there is a sell-off for example).

The VIX index, widely known as a gauge of fear in the market, is calculated by the implied volatility of options on the S&P 500 index. So when you hear someone say that the VIX is up, it simply means that the implied volatility (and by extension, price) has risen for the S&P 500 options.

Hedging

A common use case for options is to hedge a position against potentially adverse result. Lets say, for example, that a stock has been going up for a good while and the investor thinks it is getting overvalued. The investor does not want to sell his position because he has a long-term portfolio, but it would be nice to lock in those gains and have protection against downside risk. He could buy a put option with a strike price near the current market price. This gives the investor the right to sell the shares at the strike price in case there is a sell-off and price of the underlying stock heads sharply lower. Note, however, that the investor still does not have to exercise the option and sell his shares. He can just simply sell the option itself, which has now become more valuable due to the change in the underlying stock price. Using options this way can be thought of as a form of insurance.

Buying Shares by Selling Put Options

Another interesting use for options is to buy shares at a pre-determined price by selling put options. This is very useful for the long-term oriented investor who is interested in buying shares in any case to build their portfolio.

Lets say, for example, that a stock is trading at $20. The investor thinks it is a little expensive at $20, but she would be willing to buy it at $18. A put option with a strike price of $18, expiring 3 months from now, is trading at $0.30. The investor decides to sell one option at this price. She receives the option premium immediately, which becomes $30 when you multiply the option price by 100. Now two scenarios are possible when the option expires: the price of the underlying stock is either above or below the strike price. If the price is above, the option will expire as worthless and the seller of the option gets to keep her $30. If the stock has fallen below the strike price, the option will be exercised and she will buy 100 shares of the company at $18 a share. But since she already received the $30 from selling the option, she effectively purchased the shares at $17.70.

Looking at the above example, both outcomes seem favorable. The investor either gets $30 or she gets to buy shares at the effective price of $17.70, when she would have bought anyway at $18. What is the downside? Well, the downside is that for those 3 months, she (or her capital, to be more precise) was tied up in this contract. This can be thought of as an opportunity cost by not having that capital available for other investments that may come up during those 3 months. Another risk is that the shares of this particular company could go even lower than $18 and represent an even better opportunity which she could have exploited if she had not used options.

Additional Income from Selling Call Options

Finally, options can be used for generating additional income to supplement the dividend payments that the investors receives from her portfolio. This strategy is implemented by selling call options with a higher strike price than the current market price.

Like in our previous example, a stock is trading at $20. It happens to be in the upper end of the range where this stock has previously traded. A call option with a strike price of $22, expiring 3 months from now, is trading at $0.30. Our investor has a position in this stock and decides to sell one option at the market price. Like before, she receives $30 for selling the option. Again two scenarios are possible: the price of the underlying stock can be above or below the strike price of the option at expiration. If the stock price is below the strike price, the option will expire as worthless and she gets to keep the $30 which was her goal all along. However, if the price is above, the option will be exercised and her shares will be called away at the price of $22 a share.

If all goes well, the stock price stays below the strike price of the call options and the investor continues to sell a new call option every 3 months. This generates a quarterly payment in addition to the quarterly dividend payments that the company pays. The main risk is of course that the investor loses her position if the option is exercised. This is why it is important to select a strike price that is considered to be a fair price by the investor. In our above example, the investor had determined that she would not mind selling at $22.

Conclusions

The purpose of this post is to introduce some basic strategies and use cases for stock options. I think these ideas can be particularly useful for the long-term oriented investor who is not interested in active trading. Of course, for traders there are so many things that can be done with options, but trading is not really my focus on this blog. While options (and derivatives in general) can feel a bit intimidating for beginning investors, I think they are definitely worth learning about. Yes, they are a little more complex than just buying a stock and holding it, but do not let that stop you from learning them. The downside for options is that since they work in units of 100 shares, it is not possible to use them for smaller positions. Another thing to note is that options work best with large blue-chip companies since their options have good liquidity while the options of smaller companies usually do not.

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