Options are viewed by some as speculative investments, and there is some truth to that. When used in certain ways, option trading can be highly speculative, and you can lose everything.
In truth, options are among the most flexible of tools, and can be used to speculate and increase risk, or to reduce the risk compared to standard stock investing.
One way to use options in a reasonably conservative way is by selling put options that are cash-secured.
Selling Put Options: Buy Stock at Discounted Prices
Options allow investors to agree on future stock trades. The way a put option works is, the seller (writer) of the option sells to the buyer the option (but not the obligation) to sell stock at a certain price to the seller of the option before a certain date.
It helps to highlight with an example.
Jack currently holds 100 shares of XYZ company stock at $50/share. He would like to be able to sell his position at a certain price in case it drops by a big amount. Jill thinks very highly of XYZ stock, but thinks $50 doesn’t leave a very good margin of safety, and would be much happier to own the stock at $45. So she’s not buying at the current price, but has her eyes on it. She doesn’t care about predicting stock price movements; she just wants to buy good companies at good prices, and determined via the Dividend Discount Model or some other stock valuation method that $45 would be a good price to pay.
So Jack and Jill make an arrangement. Jill sells an option to Jack, for $3/share, to potentially buy the stock at $45/share within the next 12 months. In this scenario, Jack pays Jill $3 per share (or $300 for 100 shares in this case), and Jill is now obligated to buy the shares from Jack at $45/share if at any point he wants to sell the shares to her in the next 12 months. The reason Jack paid Jill is that Jack has increased his flexibility (because he has the option but not the obligation to sell the shares at $45), and Jill has decreased her flexibility (because she now has the obligation to buy the shares if Jack exercises his option that she sold him).
The trick for Jill, however, is that she wants to buy the shares at $45 anyway, so she’s getting paid to do what she would want to do anyway. If it’s a cash-secured put, she’ll leave $4,500 in cash aside over the next year to potentially be used to buy the stock. An alternative is, she could just put that money into cash positions or bonds and wait and see if the stock price ever drops to her entry price of $45, but she’ll potentially make a better return this way, since she gets paid to wait.
Jill’s potential cost basis in this stock is $42, which is determined by the strike price of $45 minus the premium of $3 she was paid. That’s a pretty good cost basis considering that the current share price is $50.
Scenario 1: XYZ stock goes to $60
If the stock jumps from $50 to $60 during some time over the next 12 months before the option expiration, then obviously Jack won’t exercise his option to sell the shares to Jill for $45. His option will expire, and he’ll have basically wasted his money on it, but he’s happy anyway because he made money. If he had not bought the option, he would have went from $50 to $60 for a 20% gain, but instead, since he paid $3/share for the premium, he only made $7/share, so his return was 14%.
Jill, meanwhile, is reasonably happy. She made $3 per share and the option expired, so her money is freed up now, and she is no longer under the obligation. When she made the deal, she had to front approximately $42/share to get it, so her return was a bit over 7%.
Scenario 2: XYZ stock stays at $50
The stock is at $50, so Jack is not going to exercise his option, and it expires worthless. He’s not particularly happy, because he made a mild negative return over this period. If he would have not bought the option, his return would have been 0%, but since he did buy the option, he’s down about 6%.
Jill is reasonably happy in this scenario, because her result is identical to the last scenario. She made $3 and the option expired, so her money is freed up, and she made the same 7% return. Being the seller of the option caps the return that can be made, and in both Scenario 1 and 2, she hit that cap.
Scenario 3: XYZ stock drops to $44
In this scenario, the stock drops to $44, so Jack forces Jill to buy the shares at $45. Jack isn’t exactly happy, because he lost $5/share from the drop, and another $3/share for the option premium.
Jill is reasonably happy, because her cost basis was only $42 (strike price of $45 minus the $3 premium she was paid), and she gets to buy the stock at the price she wanted. She now holds shares of a good company at a good price.
Scenario 4: XYZ stock drops to $30
In this final scenario, the stock drops to $30, and Jack forces Jill to buy the shares at $45. Jack isn’t happy, because he still lost $5/share from the drop and another $3/share from the premium, but he is a bit relieved that he didn’t get hit with the full drop from $50 down to $30.
Jill isn’t very happy either. Her cost basis in the stock was $42, and she owns the shares at $30/share now. It’s still better than if she had bought the shares at $50; selling put options gave her a significant buffer to protect her cash. But she still lost paper wealth.
Jill’s view at this point will depend on why the stock dropped. If the company reported rather bad news, then she’s not very happy, because she’s a fundamentals-based investor, and the fundamentals of the stock deteriorated. If, however, the stock price dropped due to a global recession and she believes the shares are undervalued, then like a true value investor she’ll not be unhappy even with a paper loss, because she recognizes that the true long-term value of the shares she is holding is higher than the current price.
More Details
The returns that can come from selling puts can vary substantially depending on what type of option trading you do.
The lower the strike price is compared to the current share price, the less likely it is that the option will be exercised, but the lower the premium will be. The higher the strike price is compared to the current stock price, the more likely it is that the option will be exercised, but the higher the premium will be.
For example, if Jack and Jill’s strike price was $50 instead of $45, then there would be a greater chance that Jill would end up owning the shares, because the stock only has to stay roughly flat or move downward a little bit for Jack to want to exercise the option. But in this scenario, he’ll have to pay Jill a higher premium. For example, Jack might pay Jill $7/share, so her return if the stock price stays flat is a nice 16.2%. Her cost basis would be $43.
Put option pricing is dependent on several variables. For a value investor, the primary variables to consider are:
a) The longer away the option expiration, the higher the premium will be.
b) The more volatile the stock is, the higher the premium will be.
c) The higher the strike price is, the higher the premium will be.
Conclusion
There are a variety of reasons why investors would buy or sell options.
The buyer may want insurance on his holding. Alternatively, someone who doesn’t even hold the shares may buy a put option to speculate that the stock price will go down, so he can make money.
The seller may be speculating that the stock won’t go down to the strike price, and that she’ll get good returns on her capital. (Selling put options can sometimes provide double digit returns when the option is not exercised). Or, the seller may be a value investor, and is looking to get paid to wait until prices meet her target buy prices.
Out of all these scenarios, the only path I take is the last one: to occasionally sell puts due to wanting to own the stock at the strike price based on conservative valuation methods. The goal is to be happy regardless of whether the option is exercised or not. If the option expires worthless, then I make a decent single digit or double digit return on the cash I secured to potentially buy the shares. If the option expires in the money, then I acquired shares of stock at a target price that I found to be quite good.
An enterprising investor can potentially sell a put option in a conservative way in order to deal with moderately overvalued markets. If there aren’t a lot of good values out there, then consider selling puts at strike prices that are more reasonable.
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