The general public has become more familiar with options trading thanks to Keith Gill’s trading in GameStop (GME), which made him millions of dollars in a relatively short amount of time using the market equivalent of lottery tickets. While options can generate outsized returns, they can also lead to wealth destruction.
Options can be thought of as insurance policies on securities, providing an individual with protection in the event that a stock or index fund makes a large move. As with insurance, there is a counterparty that takes a premium payment in exchange for covering the risk. Insurance companies can make a decent return on investment most years, but they can also lose billions of dollars and potentially go bankrupt if they are not careful writing their insurance contracts.
Investors looking to protect themselves from a large decline in a stock they own might buy a put option, giving them the right to sell their stock at a certain price for a fixed time period. For example, say an investor had a large position in Hershey (HSY) that you were looking to use to fund a college education or a new home in a couple of years. Shares recently traded around $182 per share, having declined from a high of $274 a share last year. Had the investor bought a put contract last year to sell the shares at $260, they could have protected themselves from $76 per share of downside with the purchase of the put contract that might have cost $2 per share. The party selling the put contract would then be forced to sell the Hershey shares at $76 above the current market value, a big loss for a $2 insurance premium.
Conversely, Gill purchased call options for GME, giving him the right to buy shares at a set price in the future. He bought options that were priced well above the market price at the time of purchase, making the contracts relatively affordable. The stock price subsequently increased as Gill and others talked up the stock, which allowed Gill sell some of the contracts to pay and pocket the amount above the exercise price to help pay to exercise the other contracts. Nassem Taleb and other quantitative investors use a similar strategy when they see options contracts that are mispriced. To win with the out of the money call strategy, investors often have to write many contracts and hope that they have enough winners to leave a profit after paying premiums.
As a long-term investor in Star stocks, I don’t have the time to constantly watch for mispriced options. Occasionally, I do sell puts on Star stocks that are close to a reasonable price but not quite at the level that I would require to have a margin of safety. Consider Hershey currently trading at $187.30, which is approximately 24x last year’s free cash flow. If I think the stock is worth closer to $160, I might sell a put contract that would put my cost basis near $160 if exercised. Currently, there is a February 21, 2025 put with a strike price of $165 selling for $5.50. With 242 days until the expiration date, that would equate to a simple annualized yield of 5.2% (365 days/year ÷ 242 days x $5.5 premium ÷ 159.50 capital). The actual pre-tax return is closer to 5.5% since we receive the premium in advance and can invest that money in Treasuries or other liquid funds.
That return is not better than the current Treasury yields, so it wouldn’t be attractive considering we would have to pay short-term gains if the contract wasn’t exercised. However, there have been similar scenarios where I have been able to sell similar contracts on Star stocks and gained a risk premium of 12% or more. While any stock can go to zero, this is a much lower risk with Star list stocks. Overall, options are a distraction from long-term investing, and I only use them sparingly to generate decent returns on cash when there are 1) few attractive options and 2) the premium is enough to justify the opportunity cost of tying up the money.
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