Don't Be Afraid of Options - Part 4: Buying Puts as (Expensive) Insurance

Let's face it...nobody likes accidents, not car accidents nor accidents in his/her investments.  For the former, we all have liability insurance to protect us against lawsuits and comprehensive insurance to protect us against losses due to accidents or theft.  For stocks, there is a way of buying insurance and that's by buying put options for that the same stock of which you hold shares.

As you recall, by buying a put option, you have the right to sell a certain stock at a certain price before a certain date.  So, if your stock dips below the strike price of your put option, the option becomes in-the-money and you can exercise your option.  By doing so, you can sell your shares at the higher strike price, thus, limiting your loss.  This all sounds good until you find out what the premiums are for this insurance.

Hefty Insurance Premiums
For my car (I just bought a 2006 Toyota Prius for $14650 CAD), I'm paying about $120/month of insurance.  A majority of that cost is in liability insurance.  A small portion is for comprehensive (the portion that actually covers my car).  I don't know the exact breakdown, but I believe it's something like 80-20 split.  So, effectively, I'm paying about $300/year to insurance against the cost of my car.  That is about 2.0% of the cost of my car for 1-year's worth of insurance.

Now, let's look at the cost of buying a put option to insure against your investment.  Um...let's look at Apple today (Ticker: AAPL).  The price of AAPL shares are $262.55 at the time of writing.  Let's say you had 100 shares of AAPL and were really worried about that iPhone 4 antenna.  So, you decide to buy 1 contract of a put option at strike price of $260 that expires in August 2010.  That will set you back a cool $6.00/share as it is currently priced.  Notice that this option is out-of-money because the strike price is $2.55 below the current share price.  If the stock falls below $260 before the 3rd Friday of August, you can exercise the option and be able to sell your shares for $260.  But how much is the premium that you are paying?  That's easy enough to calculate...$6.00 (price of option) divided by $262.55 share price = 2.3%.  So, you are paying a premium of 2.3% per month to insure your investment!

Things get a little better if you opt for the longer term.  If you decide to buy the same option that expires in January 2012, the price is $46.69/share.  That works out to be $2.60/month or 1.0%/month.  It all sounds good except when you really look at the implications.  Since you paid $46.69/share for that put option, you are down $46.69/share right away...poof...gone!  Before anything even happens, you're down 17.7%!  In fact, for you to break even, AAPL needs to rise to about $309.

So, why would anyone buy a put option for insurance purposes?  Actually...yeah, why?  If I wanted to hold AAPL until August, what I could do is simply this: buy AAPL at $262.55.  If it drops by $8.55 ($6.00 cost of option + $2.55 since the strike price is at $260), which is exactly how much it would have cost me to buy a put option with strike price of $260, I would sell the shares and say, "OK, that's enough for me."  That would have the same effect as buying the put option.  If instead of dropping, it rose in price, I don't have that $6 premium weighing down on me; I start making money the moment it rises above $262.55.  One caveat is that if the price drops a huge amount overnight (i.e. more than $8.55), then your loss would be greater because the next morning, you would have to sell at the lower share price.

Conclusion

In theory, buying a put option as an insurance policy is a very prudent move.  However, in reality, put options cost so much that they outweigh any benefits that they provide.  I do not recommend using this strategy unless for some reason, the put option is priced very cheaply.  Plus, if you have done your homework and know exactly how much your stock is worth, then when the price goes down, you would actually want to buy more to accumulate the stock!  That, however, is the topic of another post!  For you Canadians, have a good long weekend!

Google's Current State of Affairs

Smartmoney had a good article on Google.  The author touched on every important point about the company including search, Youtube, Google TV, and Android.  He gives a good look at the current state of the company. His conclusion?  Google probably has a long way to grow.

It's probably not a stretch to compare Google with GM and Toyota in the mid 1900s, or Nokia and Microsoft in the 1990s.  These companies were all leaders early in a long growth cycle and their stock prices reflected that growth.  The internet boom is far from over!

Don't Be Afraid of Options - Part 3: Selling Call Options

As we discussed in our last post, we know that the value of an option decreases as time passes.  There is a way to profit from this phenomenon: we sell the option!  Before we get right into the nitty gritty options selling, let's dissect the behaviour of an option using a graph.

Graphing the Behaviour of an Option

If you surf websites that talk about options, chances are you'll see a graph similar to the one below.  Don't be afraid of graphs!  They give us a lot of information in a very compact format.  Going back to the figure below, you will see a typical line graph.  On the vertical axis, we have plotted the gain.  This is how much money you will be making (or losing).  On the horizontal axis, you have the stock price.  The blue line is what the gain is at each stock price.

In the first post of this series, we talked about buying a call option.  The graph below shows how much money you would make if you had bought 1 contract of a $55 call option of WMT when the share price was at $50.  We are looking at the gain at the time when the option expires.  I have assigned a cost of the option at $2.50/share.  So, doing the math, we figure that we would have paid $250 for the option ($2.50/share x 100 shares/contract).  If the share price were to rise to $62 at expiry, the call option would be worth $7/share (you have the right to buy a $62 share at $55, so $62-55 = $7).  So, you would have a cool $700 in your pocket.  Since you paid $250 initially, your gain would be $700 - $250 = $450.  Looking at the graph, find $62 on the horizontal axis, go up until you hit the blue line, go back to the left...and there, it's at $450.

Say you weren't as lucky and WMT's share price rose, but to $53 only.  At expiry, you still have the right to buy the shares at $55, but you really wouldn't want to because you could just as easily bought it for $53 on the open market.  So, your option is useless and is worth a big fat 0!  Since you paid $250 initially, and the option is worth $0, you gained a negative $250.  This is exactly what the graph tells you as well.

So, what's that yellow vertical line...it's just a reminder of what the share price was when you purchased your option.  It really doesn't do anything.  So, there you have it, a graph of the behaviour of buying a call option.  You essentially lose money unless the WMT rises to $57.5 or above.  At that point, your gain is highly leveraged.  If you are not that lucky, and WMT rises only a little or even falls, then the most you can lose is $250.

Buying a Call Option

Writing (Selling) Call Options

Before I begin talking about selling options, let me tell you a little story about my misconception about options.  When I was first introduced to options, I thought that there was a company (probably the same company of the underlying stock, Walmart in this case) that issued all of the options for investors to buy and sell.  When I logged onto my brokerage account to buy an option, I thought that option originated from that particular company.  That notion is actually false.  Options exist because someone else wants to sell that particular option.  The Chicago Board Options Exchange (CBOE) simply gives the various options a symbol and acts as an exchange in which these transactions occur.  An investor (or hedge fund manager, etc.) actually has to write (sell) an option in order for it to exist.  Underlying companies do occasionally issue instruments similar to options, but they are called warrants.  Warrants typically have long expiry dates.

Let's now look at selling a call option.  What actually happens?  You or any other investor is able to sell an option as long as it is listed on the CBOE (or whichever options exchange at your location).  Recall that an option gives the owner the right to buy a stock at a certain price before a certain date.  So, when you sell an option, you are actually giving that right to someone else.  If instead of buying the call option we discussed above, you sold it, the person who bought that from you now has the same right to buy WMT at $55 before the expiry of the option.  By selling that option, you have to guarantee that right!

So, if you didn't own any WMT stock and you sold that call option, your gain would be as illustrated in the graph below.  First, when you sold that option at $2.50/share, the buyer pays you $250 up front.  Yay, free money!  Not so quick!  If WMT fails to rise above $55, then you're in luck.  The option is worthless and you've made $250.  What happens if WMT rises to $62?  At any time the option becomes in-the-money, the owner of the option can exercise it.  That means you would need to sell him that WMT option at $55/share.  So, if WMT rises to $62 at expiry, the broker of the owner of the option automatically exercises it for him.  You are on the hook to provide 100 shares of WMT at $55/share.  Now, since you don't actually own any shares of WMT, you have to buy them from the open market at $62/share and sell them to the option owner at $55/share.  Effectively, you have lost $7/share or $700...taking into account he paid you $250 initially for that option, you would have lost $450.

If you were really unlucky and Target goes bankrupt, driving all business to Walmart, and Walmart's stock rises to $90, you would lose $35/share ($90-$55) or $3500.  Taking into account the initial $250, your total loss would be $3250.  Now, for $250, is that really worth it?  Why would anyone sell a call option?  You are absolutely right!  Not many people would.  When you sell a call option without actually owning any shares of the underlying stock, it is called a naked call, probably named so because you're exposed to huge losses!  You have limited gain and unlimited loss.  Chances are your broker would not allow you to sell a naked call unless you have a margin account and can cover the potential losses.

Naked Call

When to Sell a Call Option

It would be quite ironic for me to end the discussion without actually telling you when we should sell a call option.  Of course, I wouldn't do that to you!  One of the strategies that I like is a covered call.  As you might guess, you have less exposure than you would if you initiated a naked call.  Essentially you would sell a call option and also own the same number of shares that would cover the call options.

Going back to our example above, instead of not owning any shares of WMT, we would actually own 100 shares of WMT.  Let's say you bought them at the same time when you sold your call option.  So, you paid $50/share for WMT.  Right away, you are up $250 by selling the call option.  If the share price rises above $55 and the buyer exercises his option, you would need to hand over the 100 shares that you have at $55/share.  The important thing to remember is that he still has to pay you the amount at the strike price, namely $55/share.  Since you bought the shares at $50/share, you would make $5/share or $500.  Add that to the initial $250 and you would have made $750.

If WMT rises to $53 and the option expires, you don't need to do anything!  The option is worthless and therefore it would be stupid for the buyer to exercise the option.  You keep the $250 and the stock actually rose $3/share or $300 over 100 shares.  So, you actually made $250 more than you would have if you had just kept the shares and not sold the option.

Covered Call

What essentially happens is that if the share price rises but not above the strike price, you get to keep all of the upfront fees that the buyer paid you.  If the share price rises above the strike price, your gains get capped at that price + the initial payment you received.

Therefore, covered calls reduces the risk of your investment, however, at the expense of the gains that you would have made if the share price really skyrocketed.  So, go on now and tell all your friends who invest that options can actually reduce the risk of your investment...they'd be shocked!

More to Come

Options is really a game changer in the world of investing.  As you saw above, a simple call option gives so many new possibilities.  And we haven't even touched put options yet!  We shall continue to explore the world of options in our upcoming posts.

Don't Be Afraid of Options - Part 2: The Value of Time

In the first part of this series, I gave an introduction to how options work.  Let's now explore one of the main factors affecting the price of an option.

Your Biggest Enemy (or Friend) is Time
Let's go back to our Walmart example. If you click on "Options" on the Yahoo Finance page, you will see that the page lists out the options that expire in the current (or upcoming) month.  However, if you want to see the prices of the various options at a particular strike price, say $55 from our previous post, simply click on "55.00" and you will be brought to a page where all of the options at strike price $55 are shown (see Figure below).  As you can see, the price of the option increases as the expiry date increases.

If we think about it, it's very logical that this is the case.  Let's say we buy the July 2010 option of $55 strike price.  We only have the right to buy the stock at $55 until the 3rd Friday of July.  If we were to buy the January 2012 option, we have about a year and a half to exercise our option.  Since we have time on our side, chances are more likely that we'll be able to make money off this transaction.  Thus, people are willing to pay more for that option.

If you are a buyer of an option, time is your enemy.  Say you bought the Jan 2012 call @ $55 strike price option now.  It would cost you $2.70/share.  Fast forward 18 months and for some reason, Walmart's stock price hasn't changed a bit.  It's still sitting at around $50.  By this time, your option is about to expire, and with the share price being almost $5 below your strike price, nobody really wants to buy that option now, and so, it's close to being worthless.  So, the $2.70/share that you paid back in 2010 was what is called the time value.  You are paying for the prospect of being able to make money with the option.  There is no actual value in that option because the strike price was higher than the share price (i.e. if you were to exercise the option, you would actually be paying more than you would in the open market, which would obviously be stupid).

With an option, the longer you hold it, the more value it loses simply because time has elapsed.  However, with a plain share of stock, it would not lose value 10 years down the road; the share does not decrease value over time (effects of inflation aside).

If that's the case, it is understandable that time is our enemy.  So, how can you say that time is our friend when we're dealing with options?  It's simple...if the owner of an option loses as time elapses, then the person who sold him the option must be making money!  That's exactly the case.  Instead of buying an option, we can sell or "write" an option.  By writing an option, you are giving the right to buy shares of a stock at a specific price (for a call option) to someone else.  In return, they give you some money up front.

Understanding the writing of an option is a little bit more involved.  Let's leave that for our next post!

Don't Be Afraid of Options - Part 1

Definition of a Derivative
You have all heard of them and you all know that they're the reason for the recent economic meltdown: derivatives!  But what exactly are derivatives?  You won't need to crack open your calculus book just yet...A derivative, as defined by investopedia.com is "A security whose price is dependent upon or derived from one or more underlying assets."  So, there is an underlying asset, perhaps a stock, an exchange traded fund (ETF), a commodity, or whatever...a derivative is simply a security (something you can buy/sell) and its price is dependent on the price of that particular underlying asset.  Options are one kind of derivative.


In this series, I would like to demystify options.  Many people believe that options are risky and should never be avoided at all costs, while others believe they are the road to riches.  The truth is that options give an investor added flexibility.  One can be very risky and aim for very lofty returns or one can be very safe and enjoy dividend like payments.  Both can be achieved through options.

There are 2 types of options: call option and put option.  By owning a call option, you have the right to buy the underlying asset at a certain price.  By owning a call option, you have the right to sell the underlying option at a certain price.  This price is called the strike price.  An option also has an expiry date, usually the 3rd Friday of a particular month.


An Example
There is no better way to explain how an option works than using an example.  Let's use Walmart (Ticker: WMT) as our underlying stock.  In the figure below, you will see a table of option prices for Walmart.  It is for the September 2010 contracts (i.e. the options expire on the third Friday of September 2010).  The top half of the table shows the prices of the call options and the bottom shows the prices of the put options.

Let's say we are bullish about Walmart and think the price will go up.  The Walmart stock is currently trading at $48.95.  We think it will go to $60 in September.  So, what we do is buy an option at the strike price of $55.  The asking price of the option is $0.10, and this is the price you will likely pay if you issue a market order.  Each contract will give you the right to buy 100 shares of WMT at $55 any time before the 3rd Friday of September 2010.  One thing to note is that the price shown here is on a "per share" basis, which means the actual contract will cost you $0.10 x 100 = $10.  Remember that you will need to pay commissions on this transaction, which may increase the cost significantly.


So, we bought our September contract for $10.  Sure enough, WMT rises to $60 in September.  At this point, what is the option worth?  Well, if you were to exercise the option (i.e. exercise your right of buying 100 shares of WMT at $55), you would have made $5 per share because WMT is worth $60 right now.  So, the option is likely to be worth at least $5/share or $5 x 100 = $500 for the contract.  At this point you have 2 options on your options (sorry, pun intended).  You can either exercise your option and pay $55/share to buy 100 shares of WMT (i.e. pay $5500 and possibly sell them right away for $6000 at market price) or you can sell your option for a little over $5/share.  Either case, you will make about the same amount.  Now, lets' see...we paid $10 for the contract, and it is now worth $500...WOW, 5000% gain in 2 months (before fees)!  Now, you see why people think you can make it big with options!


So, on the flip side, what happens if WMT rises, but only to $55, or worse, it drops?  If WMT, on the expiry date in September, trades at $55, your option is essentially worthless.  Think about it...if I can buy the WMT shares in the open market at $55, why would I need an option at $55?  Worse, if the shares trade at less than $55, then the option is really worthless, because why would I want the right to buy the shares at $55 when I can acquire them at cheaper prices?  The option is called "out-of-money" when this is the case.  (In the case above where WMT is at $60 and the strike price is below this current trading price, it is called "in-the-money")  So, in this out-of-money case, your option would expire worthless and you lose 100% of your investment.  Do note that at $55, the stock has risen more than 10% from when you first bought your option.  So, you were right about WMT, but just not right enough!  And you still lost 100% of your money.


Buying a put option is essentially the same as a call option.  If the price of the stock falls, your option will increase in value, similar to how the call option increases in value as the price of the stock rises.  The put option would be in-the-money if the stock price falls below the strike price.


As you can see, buying a call (or put) option alone gives you great leverage, but you could also lose your entire investment.  As such, I never encourage having a significant portion of your portfolio in options only.


Sounds Like I Should Be Afraid of Options!?!
Not so quick.  Options do have a huge advantage.  Let's go back to our successful example above.  By investing $10 + fees, your potential returns are limitless.  If WMT skyrockets because of fresh news or a blowout quarter, and the share price rises to $70 (you make $1500), you could have 15000% returns!  However, if you are wrong about your prediction, the worst that can happen is you lose 100% or $10 + fees.  Your downside is limited, but your upside is limitless!  (Actually, this is true for buying shares also, but with options, you are highly leveraged and your upside can be very high easily.)


This post is just a very brief introduction to how options work.  In the next post, I will talk about the factors affecting the price of an option.  As you can see in the table above, there are so many options you can buy on just 1 stock.  We shall explore which options to pick with different goals in mind.  Have a good weekend!