What is...? Part 3: Options

For those of you who perhaps missed it, ATI Wealth Partners is being featured in a series on young investors in USA Today.  The first two articles came out earlier this month, you can check them out here and here.

What now?  Is it time to sit back and rest on our laurels?  No!  It is time to forge an empire.  And by “forge an empire” we mean “bring back the summer educational series!”  Those of you who were with us this time last year hopefully remember the What is…? articles on cash and stocks that we wrote last summer.  If not, feel free to click the links and refresh your memory, we'll wait.

(starts mental countdown.....3.....2.....1....)  Ready?  Good.

This month we’ll be looking at options - if you’ve talked investing with us at all you’ve probably heard us mention options at some point.  We think they are a valuable tool for both conserving and building wealth (especially given the current market environment), and are something we regularly use in our clients’ portfolios.  Hope those pencils are sharpened.  This is summer school 201 now, it’s time to kick it up a notch.

Theory

Options are contracts.  Contracts to either buy or sell a certain stock at a certain time in the future at a certain price.  There are two kinds of options - call options and put options.  Call options obligate the seller of the option to sell stock at the contract price in the future and guarantee the buyer of the contract a fixed price at which to buy stock in the future.  Put options, on the other hand, obligate the seller of the option to buy stock at the contract price in the future and guarantee the buyer of the contract a fixed sales price in the future.  With us so far?  To recap, there are four things you can fundamentally do with options contracts:

Sell a call option - You are obligated to sell stock at the contract price
Buy a call option - You are guaranteed to buy stock at the contract price
Sell a put option - You are obligated to buy stock at the contract price
Buy a put option - You are guaranteed to sell stock at the contract price

So really, options are guarantees for the buyer of the option and obligations on the part of the seller.  Now, one more little wrinkle.  Options contracts may be exercised, in which case one of the four scenarios above happens (depending on what type of option is it and which side of the transaction you’re on), or they expire worthless and nothing happens.  What determines whether an option gets exercised is the actual stock price of the underlying stock versus the contract price.

Examples!

A put option on Apple:  Suppose there’s a put option on Apple at $140 that expires on July 21.  This option guarantees the buyer of the option contract the ability to sell Apple stock at $140 on or before July 21, and obligates the seller of the option contract to buy Apple stock at $140 on or before July 21.  Let’s say Apple stock trades at $150 currently (it does), and stays at $150 until July 21.  The put option is “out of the money” and expires worthless.  Why does it expire?  Because the buyer of the contract wouldn’t exercise the ability to sell at $140 when the price is actually $150.

But suppose instead the price drops from $150 to $138 by July 21.  Now, the option is “in the money”.  The seller of the option contract is obligated to buy the Apple stock at $140 (and the buyer of the option contract gets to sell the Apple stock at $140) despite it only being valued at $138.

A call option on Netflix:  Suppose there’s a call option on Netflix at $150 that expires on July 21.  This option guarantees the buyer of the option contract the ability to buy Netflix stock at $150 on or before July 21, and obligates the seller of the option contract to sell Netlfix stock at $150 on or before July 21.  Let’s say Netflix stock trades at $160 currently (it does), and stays at $160 until July 21.  The call option is “in the money” and gets exercised - the buyer of the call option buys Netflix stock at the contract price of $150 (and the seller of the option sells the Netflix stock at $150), despite the value of the stock actually being $160.

But suppose the price drops, and come July 21 Netflix is trading at $145.  Now, the call option is “out of the money” and expires worthless.  The buyer of the option contract wouldn’t exercise the ability to buy at $150 when the price is only $145.

So, put options get exercised when the price of the stock is below the contract price of the option, and call options get exercised when the price of the stock is above the contract price of the option.

Practice

There are two main ways we employ options here at ATI Wealth Partners.  The first is when initially building a strategic portfolio.  The S&P 500 index is a position that most all of the portfolios we manage have.  Say cash is deposited into your account and we want to put that money to work.  Sure, we could buy the S&P 500 at whatever price it’s trading at right that second (let’s say $240).  OR, we could sell a put option at $238 for two weeks in the future. 

Now, provided that the sales price of the option contract is something reasonable (an annualized 5-6% or so), we will sell the put option all day long.  Yes, selling put options potentially misses out on some upside gain if the stock price goes straight up, but it also protects your money if the stock price dips.  And if the sales price yields a reasonable rate of return even if the contract expires worthless, we see that as a win-win.  We sell these put options just a little bit out of the money, because we don’t mind being obligated to buy the underlying stock.

The other way we employ options is tactically, by writing deep out-of-the-money puts on volatile stocks.  Why volatile stocks?  The more volatile a stock, the higher the option premium.  Said differently, the more volatile a stock, the further out of the money we can sell put options and still make a decent return.  These options we will sell a lot out of the money because we don't actually want to buy the stock, we just want to collect the premium for selling the options contract.

Malarkey

It’s our experience that people who have heard of options before have a view not unlike the omniscient narrator of the Grinch - something along the lines of “wouldn’t touch those with a thirty-nine and a half foot pole”.

Yes, they are “derivatives” and yes they can be risky, but they don’t have to be.  There are four levels of options trading out there.  Levels 3 and 4 can get to be super-risky because they use margin (“margin” - n. Money you don’t have).  For instance: say you sold that Apple put we talked about on margin, and it expires in-the-money.  You need to come up with $14,000 for every contract you sold in order the buy the Apple stock you said you’d buy.  And that’s where you can quickly get into trouble.  Level 2 lets you buy options.  Hard to get in over your head buying options, but real easy to lose money.  You’re essentially buying insurance on your investments, and that insurance does not come cheap.  And then there’s Level 1.  Level 1 lets you sell call options only if you already own the underlying stock, and lets you sell put options only if you have enough cash to cover the full exercise price of the contract.  Furthermore, the account will then prohibit you (us) from using that cash for anything else besides just sitting there to secure the put contract.  What we do is Level 1.

Okay, primer over.  You can get into all sorts of fancy options strategies with fun names like “butterfly”, “strangle”, and “iron condor”, but the point of this is not to give a full-on options trading class.  It’s just to help you understand something that we feel is a useful investment tool in the current environment (and explain what’s going on with that weird part of your portfolio in the monthly statements you get if you’re already a client).  What we do with options is conservative in nature - selling cash-secured puts or covered calls - yet is something we feel strongly improves the risk/return profile of the portfolio.  And sure, they can be a little complex and difficult to understand; that’s why not everyone uses them.  But we do, and we feel that your money is better off because of it.

Questions?  Great!  Our office hours are….always.  Give us a call.