Investment Musings

Question: Can Options be used to hedge your stocks?

In the stock market world, options are risk redistribution tools.   That is, you buy or sell them to add to, or reduce the risk you have assumed in owning equity stocks.  Increasing your risk can increase your profits, but it can also increase your losses should the market turn against your expectations.

This article is about using Options to hedge, or reduce the risk of equity ownership.

In this manner, Options are like car insurance.  Your life is best enjoyed paying your insurance premiums and never having any other interaction with your insurance agent – no claims.  Thus it is with options, you want to trade them (buy or sell) and hope to never exercise them.  With car insurance, your agent collects your money and he assumes most of the risk associated with a car wreck.  He also hopes that you never need him, and he that gets to keep your money.

The simplest strategy is to sell a covered Call Option.  This is explored in a different article elsewhere in this blog and I will expand only slightly herein.  Consider a point in time when your stock has just increased to a new high.  You might be tempted to sell it, and collect your profits.  However, if you do sell, you will be out of the market holding cash and will surrender all possible gains that the stock might make in the future.  In this action, you are dramatically reducing your risk of losing your profits by giving up all future gains.

Alternately, you could sell a covered Call Option.  Here you capture some of the profits in cash and surrender only a portion of the potential future gains.  Consider that you own 100 shares of the SPY index fund, which as of this writing is trading at $212 (an all time high).  You could sell a Call with an expiration date a month in the future and a strike price of $212 for$3.  This would lock-in $3 worth of your profits.  If the stock falls back to $209 in the next 30 days, you will still have the full measure of your profits.  If the stock continues to rise to $215, you will still participate in those gains.

Only if the stock falls below $209 will you lose some of your profits, and that loss will be mitigated.  Only if the stock rises above $215 will you be surrendering future profits.

You could adjust the risk redistribution by anticipating where the stock might go.  You could look back 3 months and notice that the stock has risen $6 in the past 90 days, thus you could estimate that SPY might be trading at $214 one month from now, if it continues along the same rate of increase.  Also, you could notice that the last trough point in the trading pattern was at $208 one week ago.  From this you could estimate that the SPY price is likely to remain between $208-214 for the next month.  There is no guarantee of this; it is only a reasonable estimate.

So, you could improve the profit you capture by selling a covered Call that nets $214 (strike price plus the premium).  As of this writing, that is the $210 Call option selling for $4.  Therefore, you will put $4 worth of profits into your pocket, and if the SPY price remains above $210 your stock will be called away at that price.  The net effect will be the same as if you had sold the stock for $214 ($2 above the current price).  Or, you can buy back the option just before expiration.  At this time, the Call option’s value will be exactly the difference between the strike price and the trading price ($214-$210 = $4).  Thus, you will give back the premium received when you sold the Call, but retain the unrealized profit in the stock. – break even.  A more common approach is to buy back the Call and sell another one for a higher net value.

If the stock falls below $210, then you get to keep the stock and the $4.  Thus, you will still have the net value of $212 until it falls below $208.

Be sure to consider the broker transaction charges in your actual profit calculations.

 

Question: What is a covered Call option?

Answer: Options are a tool that investors use to redistribute the risk associated with their investments.  Options are insurance.  Some experienced traders, trade options as though they are investments themselves, but beginners should shy away from this.  However, selling covered Calls is the safest investment strategy available.

An option assigns a dollar value to a future action – it predicts the future.  The simplest case is when you own 100 shares of XYC, you can sell one CALL option contract.  This is known as selling a covered Call.  If the XYZ stock is currently trading at $50, you could sell a covered Call with a strike price of $51 for $1.  Each option contract is for 100 shares, thus you will get $100 (minus transaction fee) for the sale.

What you are doing, when you do this, is reducing your risk associated with your investment.

When you bought the 100 shares of XYZ, you invested your money in the company with the expectation that your investment would increase in value.  However, you knew that there was a risk that the company’s value would decline or that the entire market could decline (or even crash).

You can reduce your risk if you are also willing to reduce your potential gains.  Call options exchange current risk for future gains.

The Call option has no intrinsic value as long as the XYZ stock remains below the strike price.  In the case above, the 51 Call option will expire worthless as long as the XYZ stock value remains below $51.  When the option expires, you get to keep the $100 that you received when you sold the covered Call.  Thus, if XYZ should actually decrease in value, your loss will be diminished by the $100.

It is possible to increase your rate of return if XYZ increases in value at a slow rate.  If XYZ is valued at $51 when the option expires, the option will be worthless and you will earn the $100 from the increase in XYZ stock price plus the $100 from the sale of the covered Call – double the return of the stock itself.  However, should XYZ be valued at greater than $51 your stock will be ‘called away’.  That is, you will be forced to sell your 100 shares of XYZ at $51 regardless of the current value.  As you can see, your potential gain from the increase in stock price is capped at $52 ($51 strike price + $1 for the covered Call).  Any gain beyond this goes to whoever bought the Call from you.

It is impossible to lose money selling a covered Call.  The worst that can happen is that you will not earn as much money as you could have – if you had not sold the covered Call.  The XYZ stock can go down, and thus you will lose money on this investment, but the action of selling the covered Call can only reduce this loss – not add to it.

Note that options have expiration dates.  Some are a week in the future, while others are months or even years.  In the case above, where the Call option strike price was greater than the XYZ stock value, this option is an ‘out of the money’ option and the $1 value is known as ‘time value’.  If the XYZ stock value increases above $51, then the option will be ‘in the money’ and have a value that is a combination of its time value and the difference between the stock value and the option strike price.

For more information, ask me or consult your financial advisor.

 

Question: I have a lump sum of $90K from an inheritance and I want to preserve this purchasing power to give to my children in 20 years.  How should I invest this?

Answer:  Of course, this can only be accomplished if it is invested in some sort of growth instrument – because cash in the mattress will only decrease in value.

With the 20 year time frame, normal ebb and flow of the equity market is of no interest to you.  Most any diversified fund will do the job.  The risk would be investment in a single instrument that would be subject to isolated failure – remember the Enron!  While a broad market crash would certainly sink all funds, including your diversified selection, history proves with dead certainty that all losses will be recovered with time – if you don’t sell!

Even a conservative investment can be expected to double in 10 years.  Thus, a 50% reduction due to a crash 10 years from now will not impact your principal dollars and you will have another 10 years to regain purchasing power.   In a crash 20 years from now you will certainly lose a lot of dollars and you might ‘feel’ as though the market has trashed you – but at that time be sure to remember that your initial goal was to preserve the $90K and that goal was achieved.

In summary, your only path to failure is failure to invest the money in the first place.

In choosing your investment instrument you are focused on risk control.  Your goal is to maintain a very low risk for the loss of initial principal.  Additionally, you want to make the investment and then forget it.  Therefore, you should consider a fund consisting of fairly large cap companies with a very low turnover.  The large cap companies are generally ones that have been in business for decades and have a demonstrated ability to evolve their business model as the time progresses.  The low turnover will ensure a below average fund fee to minimize the long term drain on your returns.

For you, my number on choice is the DVY fund.  This pays a 3.1% dividend and has an expense ratio of 0.4%.  Therefore, assuming that nothing – inflation, market value, etc – changes in the next 20 years your investment of $90K would still be worth $90k and you would have been paid $54K in dividends (90000*0.03*20).  As you see, over time your equity investment will automatically transform itself into cash while preserving the principal investment. In real life, the equity value will grow; e.g., in the past 5 years DVY has grown 160%.  If you do nothing else, buy this and forget it.

Another choice is the IJJ fund.  This pays a 1.5% dividend with an expense ratio of 0.25%.  While it will not convert your equity holding into cash as quickly, it will create more equity investment over time.  Thus, at the end of 20 years it will probably have created the same quantity of cash.   In the past 5 years IJJ has grown 220%.

While these two funds are more or less independent of each other, they are managed by the same company.  Thus, to isolate a possible failure of the company (which has not impacted investors in the past but…who knows…) you could consider the VIG fund.  This is more or less identical to the IJJ fund but has not performed quite as well in the past 5 years.  Note that past performance is a poor benchmark to judge such comparisons.

For some diversified excitement, I really enjoy the PHO fund.  This fund in itself is not diversified as it focuses on companies that manage water resources.  I believe that energy is a basic human need and energy based equities should be in everyone’s portfolio.  And beyond that, water is truly fundamental to human survival.  This fund is largely overlooked as its focus is so non-sexy and low tech, but in a long term portfolio this is an exciting investment.  It pays a 0.5% dividend and has a 0.6% expense ratio, but in the past 5 years it has grown 170% and shown itself to be fairly immune to market fluctuations.

Your first step is to open a brokerage account.  I use TD Ameritrade and Scottrade.  There is little expectation that the failure of a brokerage firm will cause you to lose money, but as you want to plant your money and forget it, I would suggest opening accounts in both of these.  Put half of the money into each account.  In one split your money 50-50 between the DVY and PHO funds.  And in the other split between the IJJ and VIG funds.  Then sit back and do NOTHING!  No matter how the markets may fluctuate don’t do anything. Over time the accounts will accumulate a large cash holding.  You might be tempted to invest this cash.  Don’t!  Remember your goal of having the purchasing power of $90K at the end of 20 years.  This large cash holding will be decreasing in purchasing power as time marches, but it will be the bedrock of your low risk portfolio as you near the end of the 20 years and want independence from market fluctuations.

 

Question: What are PUT options?

Answer: Remember when I said that stock options were like car insurance?  Well PUT options are the essence of that idea.  In the normal application, one buys a PUT to insure their gains against loss.  Just like car insurance, you buy it and hope that you never need it.  You hope that the money spent is gone down a rat-hole because if ever you must collect, it will be a sad day.

Like CALL options, PUTs have a strike price and an expiration date.  Say that you bought SPY stock at $180 and now it is up to $213.  You can just taste that $33 profit, and want to cash out to ‘realize’ it (yes, that is the correct term).  However, you don’t want to miss out on potential future gains.  Therefore, you spend some of your profit, to insure the rest.

You buy a PUT with an expiration 30 days in the future and a strike price of $213 for $3.30 or 10% of your profit (these prices are current as of this writing).  Now, if SPY goes below $213 before the PUT expires, you can exercise the option and sell your shares at the strike price of $213 without regard to the actual current price.  Thus, 90% of your profit is locked-in.  If SPY stays above $213, you still have 90% of your profit, and if it continues to rise, you get that profit too.

However, with PUT options, you always have to spend some of your profit and there is no way that the action of buying the PUT can ever make you money.  Thus, I prefer the slightly riskier choice of selling a covered CALL to protect profits (as discussed elsewhere).

Now, some people (and I don’t recommend this until you gain lots of experience) trade options as though they were investments themselves.  One can anticipate that the stock market will drop (Bear Market) and buy a SPY PUT without owning the equity.  If the market does drop, the value of the PUT itself will increase and it can be sold for a profit sometime before it expires.  One can do the same thing with CALL options in anticipation of a Bull Market.  Keep in mind, that like car insurance, options are rigged so that the seller has the higher probability of making money.

This brings me to what I do.

I sell naked PUTs.  That is, I don’t own any equity, but I sell PUT options.  I assume some of the risk for a portion of the gains other investors have made.  Most of the time, I get to keep the selling price as they are rigged in the seller’s favor and I am careful about exactly which PUTs I sell.  Now and again, I am forced to buy the equities when a market dips causes the buyer to exercise the option.  At these times, I turn around and sell a covered CALL for the net price I paid for the stock and wait.

In my humble opinion, this is the least risky way to make money in the stock market.  Not the most romantic or fastest, but the best return with little potential loss of principal.

 

Question: How does buying a PUT Option differ from a STOP loss order?

The use of PUT Options to help protect against equity losses due to market drops is discussed elsewhere in this blog.  A STOP loss order is a safety net to protect some portion of your profits (or initial capital) against loss in a down (Bear) market.  If you bought SPY at $180 and it is currently valued at $213, you have a $30 profit to protect.

One means is to set a STOP loss order at $200.  This in a SELL order to your broker to immediately sell (at the current market price) your shares of SPY, if it ever trades below $200.  In the event of Bear market, when the stock value falls below $200, it will automatically be sold protecting a portion of your profits and your initial capital.

The advantages of STOP loss order are:

  • There is no additional cost associated with this strategy.
  • Set it and forget it. You don’t have to periodically revisit it to keep it active.
  • You can adjust it to any value you want at any time.

The disadvantages of STOP loss order are:

  • You have no choice as to when the order is executed. The order becomes a ‘market’ order once the STOP trip value is reached.  If the market is dropping rapidly, the price you actually trade at may be some lower.  These orders were particularly painful for during the infamous ‘flash crash’ May 6, 2010.  In this (unlikely) event, the DOW index dropped 1000 points within minutes, and then recovered.  Clearly, such an event would be devastating to anyone with a STOP loss order.
  • You must set it rather low, outside the normal swing of the stock value, to avoid spurious activation. That is, if SPY routinely oscillates up and down $10 per week, significantly lower than $203 to ensure you don’t get STOPped out unnecessarily.

A PUT option will have an expiration date and you could eat up a lot of profit buying them repeatedly.  However, with the STOP order, you must set it so low as to only protect a portion of your profit.  In the above example, we only protected $17 of our $30 profit.  In the previous PUT option example, we protected $27.

However, options expire and you might eat up lots of profit repeatedly buying them during periods when the market is stagnate.

The best feature of PUT options is that you decide when to execute them.  In the event of a flash crash (which is unlikely) you have until the option expiration date to decide whether or not to exercise it, and sell your shares.  If the market drops and then recovers, you don’t sell.

2 thoughts on “Investment Musings

  1. Pingback: What to do with the flat stock market? | Mark Sterling Writes

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