12.3: Options Strategies; Covered Calls and Naked Puts
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Speculating Versus Hedging
We have discussed speculating at length. Buying and selling options is pure speculation. When traders/speculators defend their speculative practices, you will often hear, “If you feel the market price of a particular stock is going to move up … ” or, “If you anticipate a drop in price within the next six months …”, or “Options are a highly risky investment strategy, but they may be suited for the more speculatively inclined.” The flaw in these arguments is this: There has never been a successful method to predict stock prices in the short term. You may “feel” or “anticipate” that the price of a stock will go up or down, but that does not mean that it will. It is not investing, it is gambling. Plus, you may be correct but your option may expire before you are proven correct.
There is one options strategy that may be useful for a prudent, long-term investor, hedging. Hedging is a transaction or series of transactions made to reduce the risk of adverse price movements in an asset. Hedging can be thought of as insurance and although insurance can be useful in some circumstances, it is not free. You pay for the insurance via the price of the option or options and the accompanying commissions. Investors can use hedging strategies when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing except for the cost of the option and the commissions.
For example, you own 100 shares of FlimFlam.com and it is currently selling for $50. You are afraid the price will plummet within the next 3 months to $10. Therefore, you purchase a put at $50. No matter what happens, you can sell the stock for $50 … but only until the option expires! Then you must go out and buy more insurance. This is called a “protective put.” Remember, insurance is not free. Using options as insurance is one way to keep your broker very happy. If you are sure the stock will fall, why not just sell the darned thing?
How about this example? It’s late in the year and you want to sell your 100 shares of FlimFlam.com. You bought them at $2 per share and will have a huge capital gains tax bill. You are afraid the price will fall back down to $2 per share once the flimflam is uncovered at FlimFlam.com. In December, you buy the put option to protect yourself and then sell your shares in January and the tax bill is postponed until the next year. Ah, okay, maybe. Maybe there is a place in the prudent, long-term investor’s toolkit for the occasional option transaction. But they are few and far between. However, if you listen to your high-stakes broker, you may hear a different story. She tells you, "Let’s take a look at a couple of options strategies guaranteed to generate more commissions for your broker, ooops!, I meant, give you tax losses that you can forward to your CPA, no!, no!, no!, help you achieve your short-term goal of becoming fabulously wealthy and retiring in an exotic far-off tropical paradise. Yeah, that’s what I meant."
An options straddle is the simultaneous purchase or sale of a put and a call on the same underlying stock. If the stock price is volatile in either direction, up or down, you will make money providing you pass the break-even point for both purchases plus the commissions. If the stock price is not volatile, you would sell, also known as write or make the straddle and hope that the stock price does not change greatly. (Two commissions at the same time! Yippee! Your broker is really gonna’ love you!)
You see that SwindlerNFTs is selling for $50 and its price is extremely volatile. You purchase a call for $50 and a put for $50. The price of the call option is $4 and the price of the put option is $5. Now, no matter which way the price goes, one of your options will be “in-the-money.” But the call cost you $4 and the put cost you $5, so the price has to move at least $9 either way before you break-even. And we did not include the cost of the commissions. You paid two commissions for the straddle and possibly one more for selling or exercising the option. Brilliant strategy, huh? Wait, it gets better.
An options spread is the simultaneous purchase and/or sale of two or more options with different strike prices and/or expiration dates. Example: A stock is selling for $50. You buy a call option at a strike price of $50 for $5. You sell a call option at a strike price of $55 for $2. You paid $5 for the call at $50, but you got paid $2 for the call option at $55. If the stock price rises past $53, you will make money. The possibilities are endless … and so are the commissions and tax losses.
Selling Options, Also Known as Writing Options and Making Options
Usually, when speculators discuss their options trades, they are referring to buying call and put options. However, as we are reiterated often, there are two parties to an options contract, the buyer and the seller. Selling options, also known as writing options or making options, allows an individual to play the part of the casino. You become the Las Vegas casino and the option buyers are betting against you. “More often than not, the option writer is right.” Why? Did we mention that most options expire worthless? No matter what happens, the option seller gets to keep the buyer’s premium, the price the buyer had to pay for the option.
If and when Your Humble Risk-Averse Author ever begins trading options, it will be as an option seller. But that does not mean the option seller still cannot lose big. An option seller can be exposed to tremendous risk, especially if the price of the underlying stock makes a big move, up or down. The amount of risk the option seller accepts depends upon where their options are covered or uncovered. Uncovered options are also referred to as naked options. (Who says that the investment world is boring? Oh, by the way, it is unlikely that Your Humble Author will ever actually employ these options strategies. I just tell myself that I might do it someday. P.S. I have never bought a lottery ticket, either.)
Covered options allow an options seller to protect themselves against large losses. Uncovered options, also called naked options, imply the opposite; the options seller is subject to tremendous loss. The amount of return to the option writer is always limited to the amount of option premium received. However, the loss can be substantial, even unlimited in the case of an uncovered call, also known as a naked call. Using the concepts of covered options, there are two options selling strategies that can help a prudent, long-term oriented investor augment their returns, selling covered call options and selling naked put options.
Selling Options: Writing a Covered Call
You are a long-term oriented investor and you own 100 shares of a particular stock. You have been thinking of selling but you are not quite sure, though, and so you hesitate. The stock is trading for around $50. Therefore, instead of selling the stock, you can “write a covered call,” also termed “sell a covered call,” or, “make a covered call.” Since you already own the 100 shares of stock, you are “covered.” The price of call options with a strike price of $55 is currently $5. You will receive $5 times 100 shares or $500 for selling the option. If the stock price jumps over $55, it will be called away from you at $55. It is as if you actually sold it for $60, $55 for the price of the stock and $5 for the price of the option. If the stock prices stays below $55, you can write another covered call if you are still not sure whether or not you want to sell the stock. This strategy allows you to make extra money from a stock that you already own. Do you see any disadvantages? What if the stock price zoomed up to $100? Oh, well, you were going to sell it anyway, right? What if the stock price plummeted? There would be very little probability that the option will ever be exercised so you don’t have to worry about that anymore. You can now use your valuation techniques to determine if you want to still keep the stock or sell it.
Do you now see why a naked call is so dangerous? If you sold a naked call ‒ wrote the call option without having the shares ‒ and the price shot up many fold, you are now required to buy a stock for many times what you must sell the stock to the call option buyer. For example, you sold the naked put option on a stock with a strike price of $50 … and the price jumped to $200 per share, you now are legally required to buy 100 shares at $200 per share ‒ $20,000! ‒ and sell them to the call option buyer for only $5,000. You may believe that this is highly unusual but it does happen from time to time.
Selling Options: Writing a Naked Put
Again, you are a long-term oriented investor. This time, you are interested in purchasing 100 shares of a particular stock. You are not quite sure, though, and so you hesitate. The stock is trading for around $50. You have the $5,000 to buy the 100 shares. Therefore, instead of buying the 100 shares of stock, you write a naked put. Since you have the $5,000 to buy the shares of stock, you are “covered.” The price of put options with a strike price of $50 is currently $5. You will receive $5 times 100 shares or $500. If the price falls below $50, the option will be exercised and you will be legally required to sell the shares to the put option buyer at $50 per share. However, since you received $5 per share from the sale of the put option, it is as if you actually purchased the shares at $45, $50 per share for the stock and $5 from the price of the option. If the stock price stays the same or goes up, the option will expire worthless and you can then write another naked put. In any event, you get to keep the option price, also known as the premium option. Do you see any downsides to this strategy? What if the stock price plummeted to zero? What if the stock price rose? What would be the results of these situations?
Covered calls are the only options transaction that is permitted in an IRA. It is unfortunate that naked puts are not permitted assuming the IRA holder has the cash available in their account. The investment world does not recognize a put seller with sufficient cash to purchase the stock as covered. The way for a put option seller to cover a put option involves a technique we will discuss in detail soon, selling short.
One last word about options strategies is crucial to our understanding of why we want you to steer far away from options. Options are typically not tax efficient. Unlike stocks which, when held for more than one year, enjoy the tax benefits of being long-term capital gains when sold, options typically are considered short-term capital gains. However, options do often generate tax losses. Of course, tax losses could possibly be considered tax efficient since they allow us to reduce our taxable income. Nothing is all bad, yes?