- Options allow for outsized returns, but unlike most stocks, they can also lead to unlimited losses or a total loss of the investment in the best case negative scenario.
- However, returns of 1,000% aren’t rare and options are a great way to increase your income or protect your returns.
- As options have an expiration date and some carry unlimited risks, you should really only use them if you know what you are doing.
An Investiv Daily subscriber recently asked me what I think about options as I never write about them.
Options have become very attractive in this environment of low dividend yields and high price to earnings (P/E) ratios, especially for those who want to achieve extra income by writing options (writing an option involves opening an option position with the sale of a contract where the buyer gets the right to buy or sell a certain stock at a certain price for a period of time while the seller gets the option premium).
Today we’ll discuss options, different types of options, how can they be used, and when and who should use them.
Types of Options
There are two types of options, call options and put options. The price paid for an option is the option premium. Options are usually traded in contracts of 100 stocks but to keep things simple, we’ll use examples of one stock and one option.
Call options give the right, but not an obligation, to the holder to buy a certain stock at a certain price (strike price) on or before a particular date (option expiration date).
Put options give the right to the holder to sell a certain stock at a certain price on or before a particular date.
For example, you can buy or sell a call option on Tesla (NASDAQ: TSLA) at a strike price of $305 for around $35. If you are a seller of the call option, you will get the $35 immediately but if the stock is above $305 on or before November 17, 2017, you will be forced to sell TSLA’s stock to the owner of the option for $305. If TSLA’s stock price is below $305 the option will expire and you have no additional costs.
Figure 1: TSLA’s option chain. Source: Nasdaq.
When To Buy Call Options
Call options should be bought when you are convinced that the stock price will go up in the period before the expiration of the option. The benefit is that you can reach extremely high returns as sometimes you can buy options very cheaply. Also, by buying call options, the potential downside is known as you can lose only what you invested while the upside is unlimited.
As TSLA’s stock has gone up since the beginning of the year, those who bought a November 17, 2017 call option on TSLA in January 2017 have already quadrupled their money.
Figure 2: Options give potentially abnormal returns. Source: Nasdaq.
On the other hand, an investor that bought the actual stock is up ‘only’ 30%, or $70 on a $240 investment.
Figure 3: TSLA’s stock price since January 2017. Source: Nasdaq.
When To Sell Call Options
An investor that sells a call option is convinced that the stock price won’t reach the strike price or that it will be lower than it actually is at the moment of sale. In the case that the stock price is below the strike price or exercise price of the option, the option expires and becomes worthless and the obligation of the option seller also expires. The gain for the seller is the option premium received at the sale of the call option. In the TSLA case above, the premium received would be around $35 per option on a $305 strike price up to November 17, 2017.
When selling an option, the risk reward situation is opposite to buying call options as the seller’s profit is defined by the option premium while his potential losses are infinite if the price of the stock just goes up. The person that sold the above call option on TSLA received the $10 per option back in January, but is now forced to pay $40 if they want to cover their position.
A strategy to limit risks when selling call options is to own the underlying stocks. By owning the stock, the potential unlimited losses are erased by the appreciation of the stock while the premium received on the option is a nice source of additional income. This is called selling a covered call.
When To Buy Put Options
Put options should be bought when an investor needs downside protection or when they are convinced that the stock price is going to fall. For example, those who bought Advanced Micro Devices (NASDAQ: AMD) May 19, 2017 put options with a strike price of $11 made a great return on investment when AMD’s stock fell last week due to anticipated slower growth. Put options currently worth around $1 could have been bought a $0.1 just two weeks ago.
Figure 4: AMD’s May 19, 2017 $11 put option. Source: Nasdaq.
Those shareholders that bought options have protected themselves from the stock’s crash.
When To Sell Put Options
A great source of additional income can be achieved by selling put options. Let’s say you’d be happy owning Apple (NASDAQ: AAPL) at $140 but find $153 a bit too expensive. What you could do is to sell an October 17, 2017 put option for $3 with a $140 strike price.
Figure 5: AAPL’s October 17, 2017 option chain. Source: Nasdaq.
If AAPL’s stock falls to $140, you are forced to buy the stock at the price you wanted to buy it at anyway. With the sale of the put option, your purchase price is actually $3. If the option expires worthless, you gained $3 on the $137 you kept available for an eventual AAPL purchase which implies an annualized rate of return of 5.2%. An excellent return in the current environment.
Two main factors define options, the potential for extreme returns and the fact that they have an expiration date. The two factors make options a classic example of high risk, high reward financial instruments. But now the question is: should you use options?
Investors that are long stocks should really investigate how covered call options can increase their income.
Investors who are constantly buying stocks should investigate how selling put options can allow them to buy at lower prices, and thus increase their longer term returns and give them a higher yield on the cash they have.
Investors who want to protect themselves from potential loss but don’t renounce the dividends and potential upside should think about buying put options. Protecting yourself from the S&P 500 falling below 2,200 points in the period up to June 15, 2018 costs 3.4%, but you could also sell all your holdings if the S&P 500 reaches 2,200 points at no cost. Then again, you’d lose on the potential upside if the index recovers.
To conclude, options should be only used by those who know what they’re doing. It’s easy to be tempted by the possible returns but if used conservatively, options can really lower your risk and increase your returns. If you aren’t well-informed about the mechanics and the risks of using options but still want to increase your returns or limit risks by using options, perhaps the best way to go is to follow a professional that has more than doubled his portfolio since 2014 while the S&P 500 is up only 21.8%. What’s also significant is that his performance was achieved with less risk due to the fact that a position not going well is immediately closed.
In the end, it all boils down to investing basics. The main question you should ask yourself with options is what the risk is you’d be running for the expected return. When the returns are skewed in your favor, I see no reason not to use options to increase returns and lower risks.