In the next few posts, I want to talk about stock options and various strategies surrounding stock options and why most of them are bad. But before I do that, I want to make sure everyone understands what stock options are. So, the next two posts will be more basic explanation of these instruments, and then we can discuss the more advanced concepts that make many of these options strategies bad.
A stock option is the right, but not the obligation to buy or sell a stock at a specified price for a limited amount of time. It is a type of investment known as a derivative, so called because it derives its value from an underlying instrument (in this case a stock). There are 2 types of options, a call and a put. A call is the right to buy a stock and a put is the right to sell a stock. Let’s illustrate with a couple of examples.
Example 1:
A stock trades at $100 and an investor purchases a $105 call with an expiration date in 3 months for $1.00. This means that the investor can exercise his right to buy 100 shares of the stock at any time for $105 per share. He does not do that now, because the stock is trading for only $100 and he doesn’t want to pay more than he has to for the stock. If the stock trades at $110 just as his call option is about to expire, he can exercise the option, buy the stock for $105 and immediately sell the stock in the open market for $110. His profit would be $5.00 per share. Since he paid $1.00 for the option, his return is 400%.
(note: while the option is quoted at $1.00, this is a per share cost. The option itself is for 100 shares, so to purchase the option will cost 100 x $1.00 = $100)
We say that the $105 call option has a strike price of $105. This is the price above which the option will have value at expiration. The option also has an expiration date that can be anywhere from now to 2-3 years out typically. There are a few special cases where longer expiration dates are possible, but as a typical investor, you are unlikely to encounter these. Now let’s look at a second example.
Example 2:
Same as above, the stock is currently trading at $100 and the investor purchases a $105 call option with an expiration in 3 months for $1.00. The stock trades for $104 right near expiration of the call option, and so the call option expires worthless. The investor does not choose to exercise his right to buy 100 shares of the stock for $105 per share because it is trading at $104 in the open market and he does not wish to overpay for it. His loss on the option is -100% since he paid $1.00 for the option and it expired worthless.
As you can see, the call holder has a leveraged position. He can lose all his money, or he can make 5X his money in the examples above. This is why many people play (and lose) at options – the promise of a lottery ticket to get rich quick.
Now, let’s look at some examples with puts.
Example 3:
A stock trades at $100 and an investor purchases a $95 put with an expiration date in 3 months for $1.00. This means that the investor can exercise his right to sell someone else 100 shares of the stock at any time for $95 per share. He does not do that now, because the stock is trading for $100 and he doesn’t want to sell the stock for less than he can get in the market currently. If the stock trades at $90 just as his put option is about to expire, he can exercise the option, and sell the stock for $95 and immediately buy back the stock in the open market for $90. His profit would be $5.00 per share. Since he paid $1.00 for the option, his return is 400%.
Example 4:
Same as above, the stock is currently trading at $100 and the investor purchases a $95 put option with an expiration in 3 months for $1.00. The stock trades for $96 right near expiration of the put option, and so the put option expires worthless. The investor does not choose to exercise his right to sell 100 shares of the stock for $95 per share because it is trading at $96 in the open market and he does not wish to sell it for less than he has to. His loss in the option is -100% since he paid $1.00 for the option and it expired worthless.
Again you can see the leveraged nature of options. The strike price for the put option in both examples is $95.
There are 2 parts to the value of the option: 1) time value, and 2) intrinsic value. Intrinsic value represents the value you would get if you exercised the option immediately. Time value is the portion of the option price that is not intrinsic value. Time value decays as the time left on the option gets shorter and shorter. Intrinsic value is determined by how much above the strike price a call is, or how much below the strike price a put is. Let’s look at another couple of examples to clarify this:
Example 5:
A stock is trading for $106, and you have a $105 call option expiring in 1 month currently worth $1.70. The intrinsic value is $1.00 because this is the value you would realize if you exercised the call immediately (exercise call to buy at $105, immediately turn around and sell for $106 per share). The time value is $0.70 and is the extra you pay to have the optionality to buy or sell at a set price from now until expiration. As the time on the option runs out, the time value will decay until it reaches 0 at expiration. At expiration, only intrinsic value can be left (if there is any) on the option.
Example 6:
A stock is trading for $103, and you have a $105 call option expiring in 1 month currently worth $0.60. The intrinsic value is zero because you would never choose to exercise the call immediately and pay $105 for something that is trading in the open market for $103. The time value is $0.60 and is what you pay to have the optionality to buy or sell at a set price from now until expiration.
There are many aspects about options that you can learn about, such as the Black-Scholes model of pricing, using combinations of options (called spreads) to try to make a profit in different ways, or the differences between American and European style options. I don’t want to get into these things because they are not useful for the discussion I want to have in the next few posts.
The key takeaway I want you to understand about options is that most options expire either worthless or at a value that is less than what the investor paid for them due to the decay in the time value portion of the option. Most unsophisticated options traders (and quite a few sophisticated ones) lose money trading in options. It is a numbers and probabilities game, and time is not on your side, unlike with long term investing. You must not only be right about the direction the stock will go, but the timeframe over which it will happen. If you believe a stock will collapse, and buy a 3 month put option, you could be right. But this does you no good if the stock does not collapse for another 3 years. You still will have lost the entire amount gambled on the put option.
Add to this that options can be highly leveraged, so you can lose a lot of money fast if things go sideways on you. With option spreads, you can lose far more than your original investment because the leverage can be even higher.
In short, you do not want to ever be buying options – with one rare exception for a small number of people. This exception is called hedging. If you have a risk which cannot be eliminated, and is too great of a risk for you to take on, you can engage in hedging, which is essentially purchasing insurance against the loss. This insurance will cost you money, in the form of the option premium which you should expect to pay in full and then lose all of it. An example of this might be if you have a huge equity payout coming in the stock of your company, and it represents a substantial fraction of your net worth. You cannot afford the stock in your company crashing and ruining your net worth, but you are unable to sell because the stock is still restricted or hasn’t yet vested. In that case, you could buy put options equal to the amount of stock you want to protect from crashing with expiration dates that are longer than the vesting or restriction period. You will pay a substantial fraction of the value of the stock you are protecting for this benefit, and this will likely not be recovered as the options decline in value over time. However, this situation is not designed to make you money, but instead to protect you from disaster. In general, hedging is expensive, and you are better off not doing it unless you are forced to, as in the situation described above. If you do hedge, it should be for a limited time only, since it is expensive, and extended durations of hedging can, over time, cost you more than the value of the security being hedged in premiums paid.
Outside of the rare hedging scenario that is deemed critically necessary, you should not buy options. The time decay in the value of options will always be a drag for buyers of options. In the event that you do make money, much of the time it will be short term gains that are taxed at higher rates than long term gains. As we have seen, this is a major drag on after tax returns, and goes against one of our prime tenets – that we should buy and hold investments for the long term. I want to be very clear – being a net buyer of options is almost always a losing proposition over the long term. Please do not buy options. I discuss this only because I need to introduce how options work for the next couple of posts to illuminate some value investing strategies.
In the next couple of posts I will talk about selling options which can make money in limited cases. We will talk about how and why you might want to do that and how it can fit into a value investing strategy. We will also talk about common options selling strategies that many think are good value investing strategies, but that actually probably lead to inferior returns relative to simpler buy-and-hold investing strategies in the long run.
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