There are three basic types who trade options: investors, traders, and hedgers.
The hedgers use options as risk-reducing tools. Some are conservative and use option collars to preserve the value of their assets. Some are more aggressive and use options in an attempt to increase earnings – at the same time that minimal protection against loss is achieved. One such strategy is covered call writing.
Traders use options with a time horizon that's considered too short for most investors.
Investors are interested in the longer term. I seldom direct a post to investors, except to encourage non-option users to learn about collars and the benefits available from adopting that strategy. This post is targeted to 'investors.'
The investor as a hedger
Many individual investors adopt covered call writing as a strategy to provide extra income. True, they must occasionally sacrifice a big upwards move in the stock price, but on average, covered call writers outperform buy and hold investors. Compare the the returns o various CBOE BuyWrite Indexes with those of the unhedged indexes (for example, see Apr 2010 issue of Expiring Monthly, available April 19).
Others are much more conservative and use options to meet their primary investment goal: preservation of assets. Collars work as intended. The investor's portfolio value never falls below a predetermined level, but profits are limited. Over the longer-term, collars underperform a buy and hold strategy. However, during bear markets, the out-performance is huge. The question for the conservative investor is: Are you willing to take some under performance for a guarantee that assets are protected. For most, the reply is a solid 'yes.'
One alternative for the conservative group is to sell stock and replace it with in-the-money call options. See below.
The investor as an option buyer. The right way
Some investors prefer to buy options instead of stock. That may sound foolhardy because owning options belongs more in the realm of speculator than conservative investor. However, under certain conditions, it's a conservative play. If the investor chooses options carefully, this idea has merit.
1) The bullish conservative investor
When bullish, the investor wants to own stocks. If the market cooperates, the investor participates in the bull market. When the markets decline, and especially when the decline is rapid,, stockholders tend to be very disappointed.
Is there a method that conservative investors can use when their primary consideration is preservation of capital? The bullish investor wants to protect assets, but also wants an opportunity to earn money on a rally.
The play I recommend in this situation is to own longer term, in-the-money options. These options carry a delta of approximately 75 to 85.
- Participate in a rally – earning roughly 80% of the stock price increase (the percentage becomes higher as delta increases along with the stock price)
- Limited downside loss. By accepting less profit on the upside, in return the investor limits losses to the cost of the option. The attractiveness of this play can be seen during a significant market decline
- If the decline is rapid and especially when it occurs quickly, there's an added advantage. The implied volatility of the options increases, making the market value of the call option higher than anticipated. Thus, loss is not only limited, but it's less than expected. Under these conditions, the investor may choose to repurchase his/her stock portfolio and sell the calls. Alternative: Sell the calls and replace them with calls that have a lower strike price. In effect, taking advantage of a declining market with limited losses.
- Less cash is invested and the remainder can be invested elsewhere
- Readers familiar with the concept of equivalent positions may recognize that selling stock and buying calls is equivalent to buying puts. Thus, this method is equivalent to owning married puts. An effective, but expensive risk management method for risk adverse investors.
- Stock moves less than one point higher when stock rallies one point
- Negative time decay. The time premium in the option slowly erodes
- When expiration arrives and the stock price is relatively unchanged, the investor has a significant loss (from negative theta). This is the true cost of owning this type of portfolio insurance
- Looking at the portfolio, an outside observer would believe the investor is a reckless gambler because he/she owns only calls and no stock. The truth is that this 'reckless' investor is truly conservative and chose to pay cash (time value of the options) to insure the value of the portfolio. You cannot always be concerned with the opinion of others.
2) The investor as an option buyer. The wrong way
If the investor is careless and doesn't make a well-thought-out investment plan that considers all alternatives, buying options can be a very poor choice.
The characteristic of he options that makes the above plan viable is that the options have intrinsic value and are in the money.
Wanting to save money, it's attractive for the less experienced investor to buy options that are have much more time premium. This investor buys at the-money or out-of-the-money options. If truly aggressive, this investor may even invest the same amount of cash as our conservative investor, and buy many extra options for the same cash investment.
This investor is truly gambling. If the market undergoes a big rally, the payoff can be enormous. For example, with the stock at $54, a conservative investor buys long-term calls with a 50 strike price. The risk-taking 'investor' buys a larger quantity of options with a 55 or 60 strike price.
If the stock moves to 65 or 70 over the course of one year, this speculator rakes in the big bucks. the problem with this concept is that when the stock remains essentially unchanged over the same one year, the speculator loses 100% of the cost of the options, with no benefit.
When the stock price is unchanged, the more conservative investor still retains the intrinsic value of the options and loses only the cost of insuring the portfolio – and that's the time premium in the options.
3) The investor as an option buyer, owning stock at a discount
My philosophy: If you are an options trader, trade options. If you are a stock owner, buy stock, not options. [Yes, the stock owner can sell naked puts when willing to buy stock at the strike price]
Let's say one of the stocks on your 'to own' is $38 and that price looks good to you. here are some choices:
- Buy shares $ 38
- Buy ITM calls, probably with a 35 strike price
- Buy $40 calls because you think this stock is moving much higher
The first choice is straightforward. You are an investor who buys stock, and this stock, at this price meets your investment needs.
The second choice is appropriate when you want to buy stock, but are almost fully invested at this time and you lack the cash to buy stock. You have some items in your portfolio that you plan to unload soon, but right now you don't have enough cash. It's okay to buy these ITM calls, paying a small amount of time premium.
The third choice gives you the opportunity to make a lot more money, when the stock performs as expected. But this is a poor choice for you, if you are a stock trader – who seldom use options. Why?
First, buying OTM options is more of a trader play than an investor play. It's also highly risky – with a large potential reward and the possibility of losing the entire amount invested.
Next, as an stock buyer, if the stock moves to $43, you will be pleased with your ability to pay $40 per share and consider it to be a bargain. But, is it a bargain? You were ready to buy at $38 and now you are paying $40 (plus the cost of the option). That's no bargain. The fact that the stock is currently $43 means you earned a good profit on your call purchase, but if you exercise and take ownership of the stock, you paid too much.
The suggestion here is to sell those options and take your profit. If you buy options, trade those options. Don't use them as a stock substitute and wind up paying a higher price than you were willing, and able, to pay earlier. Paying $40 may appear to be a bargain, but it's an illusion because your price should have been $38. If you make an options trade, keep it as an options trade and sell those calls at some point. NOTE: this is not the same as when you buy the 35 strike calls – because your aim was to buy stock, you simply lacked the cash. And by buying ITM options, the extra cost (in time value) was minimal.