What Are Options?
Options, like forwards and futures, are financial derivatives allowing investors to buy or sell an asset at a specified price in the future. However, unlike forwards and futures, which entail obligations, options provide the right—but not the requirement—to execute the transaction. This flexibility comes at a cost known as the premium.
Options can be based on various underlying assets, including interest rates, currencies, and other derivatives. However, equity options, which are based on individual stocks, are the most prevalent and will be the focus of this discussion.
Equity Options Explained
An equity option grants the holder the right to buy (call option) or sell (put option) a specific stock at a predetermined price (the strike price) before or at the option’s expiration. Each equity option contract typically covers 100 shares of the underlying stock. For example, if an option on ABC stock has a premium of $5, purchasing one option contract would cost $500 ($5 per share x 100 shares).
Valuing Options: Intrinsic and Time Value
The price of an option consists of two components: intrinsic value and time value. Intrinsic value, also referred to as “moneyness,” measures the option’s profitability if exercised immediately. A call option is “in the money” if the underlying stock’s price exceeds the strike price, while a put option is “in the money” if the stock’s price is below the strike price. If the option would be worthless if exercised immediately, it is “out of the money.” An option is “at the money” when the stock price equals the strike price.
Time value reflects the potential for the option to gain value before expiration. Unlike intrinsic value, time value is always positive due to the one-sided payoff nature of options. As time progresses and the expiration date approaches, the time value diminishes, eventually reaching zero at expiration.
Strategies for Using Options
Investors buy call options if they anticipate a rise in the stock price and buy put options if they expect a decline. Options can also be used for hedging existing positions or to speculate on future moves in the underlying asset. Options can be valuable in portfolio management, but there are also risks and costs. For example, while hedging a portfolio’s downside sounds nice, it can also be expensive over time.
Leveraging with Options
Options allow investors to leverage their positions significantly. For example, purchasing a $5 call option on a $100 stock enables an investor to control 20 options for the price of one share. This leverage can lead to substantial profits but also comes with high risk; if the options expire worthless, the investor loses the entire premium paid.
Portfolio Insurance with Options: Protective Puts
Put options can be used to protect a position or portfolio from downside. If an investor owns 100 shares of a stock, purchasing a put option limits the downside of that position. If stock ABC is trading at $100, purchasing put options with a strike price of $90 would limit the downside to just 10%. However, those put options cost money (the premium) and have a limited time to expiration: if the stock does not fall 10% or more, the option will expire worthless at expiration and the premium lost.
Writing Options: Opportunities and Risks
Writing (selling) options can generate income through the received premiums. However, this strategy carries significant risks, as the writer must fulfill the contract’s obligations if the option holder exercises it. For example, if a written call option is exercised, the writer must sell the stock at the strike price, potentially at a loss if the market price is higher. Selling put and call options can have different risk profiles depending on if the investor owns the underlying stock already. If an investor sells a call option without owning the underlying stock (“selling a naked call”), that investor may have to buy the stock back at a higher price to fulfill their short call obligation. However, the picture changes if an investor already owns those shares.
Exiting Existing Positions while Producing Income: Covered Calls
While selling options comes with a different risk profile than buying options, selling call options on an owned position can provide benefits. By selling a call option the investor receives the premium payment, generating a little bit of income. However, the investor still owns the stock and is exposed to downside if the share price falls. Additionally, the investor sells the upside in the stock: If stock ABC traded at $100 and an investor sold calls with a strike price of $110 and the stock rises 50% to $150, that investor only captures the upside to $110, selling the additional upside to the call buyer. Therefore, selling covered calls can create risk if the stock price rises or falls. Covered calls can help exit a pre-existing position at certain prices while generating a small amount of income in the process.
Combining Options: Costless Collars
Investors can combine put options and call options to create interesting strategies. For example, an investor could initiate both a covered call and a protective put: By selling an out-of-the-money call option the investor receives a premium payment, which is used to purchase an out-of-the-money put option. In doing so, the investor has sold the upside to their position while also limiting the downside. This can be an attractive solution for an investor wishing to lock in the value of an investment without selling it entirely.
Opportunistic Purchase: Cash-Secured Put
Selling put options and holding an adequate amount of cash can be an efficient and opportunistic way to own shares. By selling a put option the investor receives the premium but must purchase the shares if the price falls below the strike price—effectively “buying the dip.” If the shares don’t dip, the investor keeps the premium and retains the cash position; if the shares do fall, they can buy them at the strike and keep the premium. Of course, if the stock continues falling the investor now owns the shares and the downside.
A cash-secured put ensures the investor has enough cash on hand to fulfill their obligation, whereas a naked put could cause the investor to scramble for cash, possibly selling other assets inopportunely. A successful cash-secured put requires short-term market timing—impossible, in our view. If the stock climbs the put options aren’t exercised and the investor never owns the shares as they continue appreciating. Thus, we typically don’t advocate for cash-secured puts. Instead, if we want to own shares, we will simply buy them.
Empirical’s Stance on Options
At Empirical, we do not advocate using options for speculative purposes due to their inherent risks. However, we recognize the prudence in hedging equity exposure with options. Our team is prepared to assist clients interested in incorporating options into their portfolio protection strategies. Contact us for more information.
In summary, options offer unique advantages and risks compared to other derivatives. Their flexibility, cost-effectiveness for hedging, and leverage potential make them valuable tools for informed investors. Understanding the intricacies of options, including their valuation and strategic uses, is essential for leveraging their benefits while managing their risks.
Disclaimers and Disclosures (optional):
- No Guarantees: The performance of options is not guaranteed. Past performance does not predict future results. The value of investments can go down as well as up.
- Risks: Options involve risks and are not suitable for all investors. They can expire worthless, resulting in a complete loss of the premium paid.
- Hedging Limitations: While options can be used for hedging, this does not eliminate the risk of losses in the underlying positions.
- Educational Purposes Only: This document is intended for educational purposes and does not constitute investment advice.
