Options contracts are the right tool for the right investor. But many more investors use options contracts than should, and unfortunately the many that should consider it, simply don't know how to use them.
Most commonly, options are a tool to leverage bets. I don't suggest that.
Yet properly used (which they rarely are), for specific investors, options can actually improve your portfolio's profile.
Financial contracts are complex, but let's distill the basic principles of the major three:
"Cash" or "Spot" contracts — trade money immediately for something. We do this everyday when we shop for groceries, or use money to buy stocks or bonds.
"Futures" contracts — trade money immediately for something, but get it in the future. You buy something from me (e.g. 5,000 bushels of wheat), but I don't deliver it to you until the future (e.g. 3 months from now, after we harvest the crop). The roots of futures are indeed agricultural, and it is not a coincidence that the famous "Board of Trade" for commodities is in heartland Chicago, rather than New York.
"Options" contracts — trade money immediately for the right, but not the obligation, to make a defined transaction on a defined date in the future.
If we stay on the same wheat bushels, it might cost:
Cash/Spot: $100,000 to buy 5,000 bushels.
Futures: $110,000 to buy 5,000 bushels, but take delivery in 3 months (someone else has to store them until then!)
Options: $15 to buy the right, but not the obligation, to buy 5,000 bushels in 3 months for $140,000.
The payoff structure of options can feel like a casino. You might think — why on earth would anyone bet that the price of 5,000 bushels would reach $140,000 in just 3 months, if the current price is only $100,000?
To which I would respond — yes. That's why it might only cost $15 to enter that contract. It's cheap because it's unlikely.
But if there is a crazy, unexpected wheat shortage that causes the price to go up to $150,000 in 3 months, then that person becomes an outsized winner despite only spending $15. They execute the options contract to buy the bushels at $140,000, then sell them in a cash transaction at the time for $150,000.
Made $10,000 and it cost you $15 to do it. That's leverage.
And you can imagine that an options contract to buy the same 5,000 bushels of wheat in 3 months for $130,000, instead of $150,000 would be more expensive (e.g. $1,500), because it's more likely to payout.
And an options contract to buy 5,000 bushels of wheat in 3 months for $300,000 might be only $1.50, because its wildly unlikely.
What was once a horse-and-buggy, critical mechanism for 19th century farmers to hedge risk and run profitable agricultural businesses, derivatives (like futures and options) are now an industry that frequently reeks of Wall Street profit motives.
At the Chicago Board of Trade today, only about 1% of futures contracts get delivered! Instead, they are traded for hedging or speculation purposes, and then the trader exits the position before the contract expires.
Last week, when Roaring Kitty purred back into our lives and started tweeting again, the options activity on Gamestop (GME) stock went berserk. Consider this from an X account that monitors big trades:
Let's break it down:
Bought call options: paid $0.21 for options contracts that gave the investor the right (but not the obligation) to buy Gamestop stock at $25/share anytime before 5/17/2024.
As Gamestop stock ("the underlying security") soared, the price someone was willing to pay for that same options contract (or, opportunity) soared even more.
The investor was able to sell those same contracts they bought for $0.21, for $13.63. They bought $27,000 worth of the $0.21's, so the $13.63's would have been worth $2M.
What's the catch?
No one knows what an underlying stock will do in the future! And so this huge win is a very rare outcome.
Instead, a more likely outcome was just losing $27,000 as the options expired worthless, and GME never got close to $25/share.
If you know that a certain asset will go up or down, options contracts are a fantastic way to leverage your bet. You can earn demonstrably more than you would just buying or selling the cash/spot contract of that asset (e.g. the stock itself).
Problem is no one knows the future. I strongly encourage investors NOT to buy call options like this.
However, there is a sensible reason to get a scalpel, move beyond plain-vanilla investing, and introduce complexity via options into your portfolio.
The strategy is called covered call options, and can reduce portfolio risk for a unique set of investors.
Covered calls are when instead of gambling on the underlying stock by buying call options, you are the person selling those call options. You collect the premium (e.g. $15) — meaning you get that amount up front that gives someone else the right (but not the obligation) to make a specific transaction with you (by a specific date in the future).
If buying the call option works out well, then as the seller you are the one who gets hosed. You are on the line to deliver the goods, like wheat bushels or Gamestop shares, at a predetermined price. So why risk it?
Because if you are a specific type of investor who already owns a concentrated position in a stock ("cash" or "spot" position), and you know the price that you want to eventually sell them, then you can lower your portfolio's risk by selling covered calls (the covered refers to already owning the underlying stock).
Sell these calls at the exact strike price you want to get out of your stock position anyway.
Let's pretend you have a $2M portfolio, and $1M is in a diversified portfolio of stocks and bonds that you are comfortable with, and $1M is in Tesla stock that you earned while working there.
Today, Tesla stocks costs ~ $177/share. So you have $1M/$177 = 5,650 shares.
You don't really want to own them anymore because you work with a really thoughtful financial advisor who told you that having 50% of your investments in one stock is risky, but maybe (1) you are anchoring to the glory days when it was $400/share, and you can't stomach selling at this low price, or (2) when you received the shares as an employee, the price was only $50/share. The capital gain taxes owed by selling at $177 are too burdensome.
But let's also say that you do want to get out of your position when/if Tesla gets to $300/share. Then you are the perfect candidate to consider selling covered call options.
Below is an options ledger of all the Tesla Call Options for $300 [I am going to make some simplifications. The takeaway readers should have is that deep "out of the money options" — unlikely to work out well, are cheap. "Close to the money" or "in the money" options — much more likely to have a chance at working out, are more expensive].
The ones expiring on May 31, 2024 (next week) are trading for $0.02. Meaning because it's nearly impossible for Tesla to go from $177/share to $300/share in this short time, they are so "out of the money," that someone will sell you any upside above $300/share until expiration for just $0.02.
But consider at the very bottom of the $300 call options ledger, the June 18, 2026 contract...a little over two years from now. Someone willing to pay about $28 dollars could purchase the right, but not the obligation, to buy Tesla stock at $300 any time before that expiration date. Since we've seen Tesla hit $400/share before, and many traders hype over Tesla, you can imagine there is an appetite for this type of bet.
And this where YOU — the former Tesla employee who wants to de-risk your portfolio, and sell Tesla stock if/when it hits $300, can come in. You are the PERFECT seller to this person, because you can collect $28 to give someone else the right to force you to sell them Tesla stock at $300/share anytime before expiration.
Because you already want to sell at $300/share! What do you care?
What you give up is any future gains above $300/share, which is what the buyer would receive. But if you were intending to sell your Tesla stock at $300/share already, you wouldn't have participated in that upside anyway!
Covered call strategies are an appropriate scalpel when you own a concentrated stock position, and are waiting for the stock to hit a certain price target to sell.
Consider selling call options at that strike price.
I often use the Groupon analogy: if you go buy 20 Groupons for random things, you probably won't use any of them and it will end up costing you money. But if you know that you are going to a specific massage parlor or hair salon, why not see if they have a Groupon? It's free money.
If you own a stock already, and you know the price you want to get out, why not collect income along the way?
Financial engineering and derivatives got a really bad reputation after the 2008-09 financial crisis. It's not entirely undeserved.
But as investors continue to wise up toward simpler, lower-cost portfolios, and avoiding typical Wall Street shenanigans, they should also know that unique situations call for unique solutions.
Not all complex finance is inherently bad. Financial engineering isn't inherently bad. Derivatives aren't inherently bad. It's just misusing them that can be bad.
End.
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