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.

Finding Quality Stocks in Helsinki

In a previous blog post describing my investment philosophy I explained that I try to invest in companies of highest quality. But how to measure the quality of a company? There are many ways of course, such as looking at the strength of the balance sheet, competitive advantage or track record of management. There are also various equity research institutions which provide metrics and rankings to measure the quality of different companies.

However, I came up with another interesting data point to look at. I have a margin account with my stock broker, Nordnet, where I hold Finnish stocks. This means that they will lend me money to buy shares, and any shares I own will be used as collateral for the loan. The stock broker has internal metrics for calculating how safe the stock of each company is, and the value for collateral is different for each company. For example, if the company is considered really safe and stable, the bank may accept 80% of the value of the position as collateral. If the company is really risky, they may accept only 30%. They will tweak these values if there are significant changes in a company, but they appear to be relatively stable.

Why is this such an interesting metric to look at? The business model of a stock broker is to earn commissions on trades and sell other services for fees. Generally they do not want to speculate which stocks go up or down, in other words they do not want to take on risk if they can avoid it. The collateral value gives us some idea of what they think a stock is worth in a worst-case scenario. This means they are putting their money where their mouth is, or in other words, risking their own money in proportion to this figure that they state. Meanwhile they will hype and advertise the IPOs of hottest tech stocks all day long but they will not lend money against their shares. Interesting isn’t it? Lets look at Rovio, for example, which went public about 3 months ago. The broker is accepting only 20% of the value of Rovio shares as collateral, which means that in a worst-case scenario the broker thinks the fundamental value of Rovio is only 20% of what it is currently trading at.

But enough about Rovio, lets get to the quality names that this blog post is about. All the links for the companies lead to the Investor Relations sections of their website.

Grade A (collateral value 85%)

These companies, according to the broker, are the safest and highest quality listings traded in Helsinki. If one were to build a portfolio consisting of just these stocks, I expect that investor to sleep well at night. There are two telecomm stocks (Telia and Elisa), so maybe owning both is not necessary. Kesko is a stable consumer goods company, one of two large companies that sell food and other necessary items in our duopoly. I think not many will disagree with my opinion that Kone and Wärtsilä are the highest quality industrial stocks we have in Finland. Sampo is our leading financial services company and Fortum is an electric utility which is not going anywhere. The only company in this list that has been struggling lately is Telia, but their share price seems to have bottomed between 3.5 and 4 euros.

Grade B (collateral value 80%)

This second group is very interesting. These companies are still of very high quality, but not quite as rock-solid as the first group in the opinion of my stock broker. Each of these companies has some specific risks which I suspect landed them in the second group. For example, Nokian Tyres has some exposure to Russia which has risks. Metso is heavily exposed to the mining sector and their share price got crushed along with the share prices of mining companies at the start of 2016. Neste has strong dependency for government subsidies in biofuels. Orion is vulnerable to expiring drug patents. Nordea is undergoing a large upgrade of their tech/software infrastructure. And being the largest bank in Scandinavia has lots of regulatory risks as well. Tieto is the largest software company in Finland, but software is an area that is easily disrupted and Tieto is very dependent on government/municipality contracts. Overall I would stay these are very good companies to own, but one should be aware of some company-specific risks.

Grade C (collateral value 75%)

Companies that belong to the third group are, according to my stock broker, slightly more risky than the first two groups. If I try to look for a common thread among these names, I think their competitive advantage is weaker than any companies in the first two groups which means they are more susceptible to disruption by competitors. They seem to lack a “moat” as Warren Buffett calls it. I don’t personally own any companies from this group. Going back to my investment philosophy, I said I wanted to own the highest quality companies, and those are found in the first two groups.

Conclusions

I found this method of ranking stocks particularly interesting because I had already formed some opinion about the quality of different companies through research and other methods, and I found there was a very strong correlation with how my stock broker ranked these companies. This strong correlation definitely surprised me. Of course, one should not buy stocks based on this list alone, but it does serve as an interesting data point to consider.

But lets say, for the sake of argument, that one would construct a portfolio using this list as a guide. A rough rule of thumb would be to own all the companies from group A, half of the companies from group B and maybe one or two from group C. This would result in a fairly safe and defensive portfolio, perfect for an investor who is interested in protecting the invested capital and not chasing quick profits.

Oh, you might be wondering where is Nokia? They did not make the list as my stock broker would rank them in group D that I did not include here. Apparently they see Nokia as a fairly high risk business. It is currently my only position that is not included in this post.

My Investing Philosophy

Since money and investing will be one of the main themes of my blog, I think it is natural to start off with a quick introduction into my investing philosophy. If I had to sum up my investing philosophy in once sentence, it would be get rich for sure. I have tried various things over the years, but one consistent lesson has been that the get rich quick methods do not work very well. So here is a brief introduction into my thoughts regarding investing for passive income.

Investing vs Speculation

Before we get started, I have to present some definitions that I use. My definition of investing means buying an income-generating asset, while my definition of speculation means buying an asset that does not provide income. These two asset types have a very clear and important distinction. An income-producing asset provides a stream of cashflow while I hold it (and that cashflow should be steady and predictable). As long as that income stream does not stop, fluctuations in the market price of the asset are not critical, assuming that eventually the market price reaches the purchase price. Meanwhile I collect the income and I really like the concept of being paid to wait. However, if an asset does not provide income, the only way for the investment to be profitable is for someone else to pay more for it at a later date. In this case the success of my investment rests much more in the hands of other investors and this feels inherently more risky to me. The less my success is dependent on others, the better I feel.

Considering these points, I think only income-producing assets are consistent with the get rich for sure strategy. I am not saying speculating is wrong, only that it should be recognized for what it is. I have some speculative assets as well, but I do think that speculative assets should not be included in the core portfolio of a starting investor.

Income-Producing Assets

Now that I have narrowed my choices to only assets that produce income, it is time to consider possible candidates which meet that criteria. Here are some examples.

Real Estate

If one is interested in putting in some amount of work, I think real estate has some characteristics that make it objectively the best asset class when measured by risk-adjusted returns. It is particularly attractive because banks are generally willing to lend money relatively easily when the real estate asset is used as collateral for the loan. Utilizing this high degree of leverage often produces good returns on invested capital. The downside of real estate is that it cannot be called passive investment until you have enough scale to hire someone else to manage the property. Another downside is that even with leverage, it requires fairly large amount of capital to get started, considering one should own multiple apartments to diversify risk. Third downside to consider is that apartments are not very liquid and can take a long time to sell.

Dividend-paying Stocks

Dividend-paying stocks of publicly listed companies are what I have chosen as my primary investment vehicle. While I expect my total return to be lower compared to real estate (at least if measured by income alone), there are some great benefits to stocks that make up for it. First of all, it is a truly passive investment that requires no active involvement. The time I save (compared to real estate) can be used for other income-generating activities such as work. The second obvious benefit is the superior liquidity provided by stocks, allowing me to buy and sell whenever I want to. And thirdly, I can perform these transactions from anywhere on the planet, as long as I have access to internet and a computer. This level of freedom wins the case for stocks in my situation.

Bonds

The problem I have had with bonds is that I have not found them particularly interesting. They are like the boring version of stocks. But they have an important distinction. Buying a bond generally means you are entering into a contractual agreement to receive payments from the issuer of that bond. If you are holding common stock however, the company can cut or even terminate the dividend payments at any time if the management decides to do so. What makes bonds boring is that you do not get to participate in any gains when the company is doing well or when it is being acquired by another company.

Farmland, Forest

Land as an investment is definitely an interesting area, and one that I will hopefully explore further in some future blog post. From what I have studied so far, it appears that farmland is good if you can work it yourself (and be efficient at it), but if you are merely buying land to rent it, the return on investment is fairly low. The main income from owning forest is to sell the trees, but the problem is that trees take extremely long time to grow. Who can afford to wait 20 years for trees to grow? Not me. One positive about farmland or forest is that they will hold their value fairly well in a recession.

Individual Stocks vs Funds

The myth most often perpetuated by the financial services industry is that average investors should just buy an index fund, and not invest in individual stocks. While this is a complex issue, I tend to disagree. The underlying message here is that the average investor is too dumb to manage their own money, so they should let some “expert” in Wall Street to manage it for them. If a person is motivated to learn, there is nothing particularly difficult or complex about stocks or finance. The confidence one gets from successfully managing their own money is also a substantial benefit to consider.

Another problem with an index fund is that the stock market as a whole can get overvalued during a bull market. As I write this, in December of 2017, the market looks very overvalued to me. This condition of overvaluation can last for many years. If the investments are made during this kind of period, the expected returns for the following years will be low, or even negative. Another option is to just wait, but that requires a lot of discipline and is not a very exciting approach. The good news is that there will always be fairly priced individual stocks, even in a bull market. This is one of the main reasons why I invest in individual stocks.

Picking Stocks

Now that I have established why I am a stock picker, what stocks am I selecting for my portfolio? To answer that question, I must begin by considering what kind of stocks are consistent for the get rich for sure theme. The most likely stocks with long term staying power are the highest quality companies which lead their own sectors. Warren Buffett has said that he would rather pay a little more to own a great company, than to buy an average company cheaply. I fully agree with him here. Of course these highest quality companies tend to trade at a premium vs their peers, but that is the price one must pay for quality. It just doesn’t make sense for me to buy average companies when I can buy the best ones. When buying an asset, I also try to consider it from the viewpoint of other investors who would be potential buyers in the future in case I want to sell. I want to own assets that other investors want to own, because that is what determines their price in the market.

Dividend Yields

Since I am investing in income-generating assets, the dividend yield is one of the most important metrics for me. In the current market environment, I look for stocks with a dividend yield of 3.5% to 4%. I think this represents a sweet spot where the starting yield is substantial enough, but the company still has some growth potential also. I almost never invest in a stock with a dividend yield below 3%. I know many advocates of Dividend Growth Investing say that the starting yield doesn’t matter, only dividend growth does. They are willing to buy a stock with a yield of 1.5% as long as it is expected to grow, but the math just doesn’t add up for me.

Number of Holdings

I think a good number of stocks in a mature portfolio is 20. This amount provides very good diversification with each holding representing roughly 5% of the total portfolio. Since additional diversification results in diminishing returns, adding more stocks for that purpose is not required. Initially when starting out, I think 5 stocks is a good number to aim for, then build your portfolio to 10, and eventually to 20. The reason why you do not want too many stocks in the beginning is to minimize transaction costs, which can be significant if you are not careful. I will be writing another blog post about how and why to minimize transaction costs later on.

Buying in Increments

One of the most important ingredients for the success of my investing strategy has been entering into positions in increments. I usually start a position by buying just 1/4 of the total amount I intend to own. Then I hope the price keeps going lower so that I can build my position with even cheaper shares. I think this is the part that is the hardest to do for beginning investors, to have conviction to double down on a position that keeps going lower, and then buy even more at an even lower price. This kind of conviction can only be built with experience. Of course the key here is to identify why the price is going lower, and whether it is a temporary problem or something that threatens the existence of the company. Often the best time to buy is when the general opinion among investors reaches the point of maximum pessimism and that’s also where the bottom in price is often found.

Expectations

My conservative expectation for return on investment is 8% annually, with 4% coming from dividends and the other 4% coming from capital appreciation. I think this figure is in line with what stocks have returned in the past as well. I realize this strategy may lose to an index during strong bull market years, but it should beat the index during bear markets. Of course my most important measure is that the passive income provided by the portfolio keeps growing every year.

Psychology

My investment philosophy is extremely rewarding psychologically. Instead of chasing quick profits and trying to invest in the newest hot IPO or trending stocks, it is a solid portfolio that is grinding consistently higher and producing ever growing stream of dividend payments. And since I am only investing in the highest quality of companies, any drop in the price of their shares is usually a positive event, allowing me to purchase more shares at a discount. Additionally, this type of portfolio requires very minimal amount of maintenance and tracking, leaving time for other interests. While I usually like to check my portfolio daily, I would do just fine checking it once a week, or even once a month.