Why selling options as part of a value strategy may not always be a good idea

The last couple of posts were dedicated to the introductory level primer on what options are, what buying and selling an option means, and how selling options can be part of a value strategy.  Many value investors think that selling options is a great part of their strategy to buy and sell stocks with some even going so far as to always try to use option selling to buy and sell stock in a company that they wish to act on.  However, in this post, I will give you a less commonly understood, but more nuanced view of options selling.  And why it may not always be a good strategy despite the premiums that you earn for doing so.

First let’s look at the the issue of lost opportunity.  When you sell an option, you are being required to wait until that option expires (usually) or until some event occurs like a dividend which makes early exercise happen.  In the meantime, while you wait, the stock price does not sit still.  Here is the problem with that situation demonstrated in 2 examples:

Example 1:

You decide that stock in company ABC is deeply undervalued and you would love to own it at its current price of $10/share because it is an outstanding company.  However, wanting more, you sell a $10 put option expiring in 3 weeks on the stock at $1.00, so that you can get it even cheaper (effectively for $9.00 / share with the option premium reducing your cost basis).  Over the next few days the stock moves up quickly to $20, and by the time the put option expires in 3 weeks the price is now $30/share.  It is no longer in deep value territory, so you don’t purchase it.  Over the next 10 years, since ABC is a fantastic company, it goes to $100 / share.  You missed out on a gain of $90/share because you tried to collect an extra $1/share.

The lesson here is that if a stock is already at a price where you want to enthusiastically buy it, just buy.  Don’t play around with options or this scenario will happen to you at some point.

Example 2:

You decide that some stock that you own in company XYZ is very overvalued and you are thinking about selling.  Further, the XYZ company’s returns on capital have been eroded by competition and you don’t think it is as good of a company as it once was.  So, you decide to sell.  The current price for XYZ company is $30/share, so you sell a $30 call option expiring in 3 weeks for $1.50.  This gets your effective selling price to $31.50 when including the option premium.  However, a few days after you sell, the stock price drops on bad news to $20/share.  You decide to wait it out, and by the time the option expires in 3 weeks, the price is now down to $15/share.  No longer in overvalued territory, you decide to hold on and finally decide to sell 3 years later when the stock price has further declined to $10/share due to deteriorating fundamentals at the company.  You missed out on selling a deteriorating company, lost $20/share in value while trying to capture an extra $1.50/share, and further had an opportunity cost of having the remaining funds tied up in the stock for an extra 3 years, when they could have been invested in a great company somewhere else.

The lesson here is that if a stock is already at such a high price where you are happy with selling it, or where the company really needs to be sold because of deteriorating business fundamentals, just sell it.  Don’t play around with options or this will happen to you at some point.

Example 3:

You like a great company that you own, XYZ, and try to earn extra income on it by selling calls.  You don’t actually want to sell the stock, and so you sell covered calls far out of the money (far away from the strike price).  Currently, XYZ is trading at $30/share and you think it is unlikely that it will reach $45/share, so you sell a call with 3 months until expiration at $45/share for $0.25.  You have been doing this for a couple of years and it is working.  However, soon after you sell a call, the stock price rises rapidly on good news.  In just a couple weeks, the stock reaches $75/share.  The stock eventually reaches $120/share by the time your call is exercised at the end of 3 months.  You effectively get $45.25 per share ($45 / share exercise price + $0.25 option premium), missing out on the rise to $120/share.  To make matters worse, you have owned this stock for many years and have a lot of capital gains that are now realized because you were forced to sell the stock.  You now owe a lot of taxes.

The lesson here is to never sell a covered call on a stock at a price you wouldn’t be happy selling it.  Another lesson is that selling a covered call may force you to sell and recognize a taxable gain, which can significantly impact long term after tax returns.

Now let’s look at yet another example.

Example 4:

You decide that some stock that you own in a company XYZ is very overvalued.  While XYZ is a good company, it is so overvalued that you decide to sell.  The current price for XYZ company is $30/share, so you sell a $30 put option expiring in 1 year for $5.00.  This brings your selling price to $35/share.  Right after you sell the call option, the XYZ stock price begins rising, and within a few weeks, XYZ reaches $100/share on news.  You are now stuck holding the stock and the sold call option for a year, or paying to buy back the call option and close things out.  If you hold for a year and the stock is at $200/share, the call gets exercised for $30, and you miss out on all the gains, while having your capital tied up in the stock for an entire year, causing you to miss out on other opportunities.  If you decide to buy back the call and just sell your stock, you only recognize an additional $3/share instead of $5/share because of the cost of repurchasing the call option, so your effective price is only $33/share for sale.

Here, if you decide to hold for a year, you lose opportunity cost.  If you decide to close out the call and the stock, you do not participate in the large gain the stock made, and you have to reduce your profit due to the cost of repurchasing the call.  This leads to an interesting situation with selling call options, called clipping the wrong end of the risk tail.  Allow me to illustrate with a few scenarios.

In the first scenario, you only buy a stock. Figure 1 represents the distribution of probable returns over some period of time (for example, 1 year). The possible stock prices are log-normally distributed. Your loss cannot be greater than -100% (0% of the current price in the graph in Figure 1), but your gains are theoretically unlimited.

In the second scenario, you sell a put.  One of two things happens: 1) you get to keep the premium and are not exercised, so you do not own the stock, or 2) you get to keep the premium and are exercised and now own a stock you want.  In both cases, you need the capital available to purchase the shares, but it is not completely tied up, since you could put it in treasury bills that mature shortly before the put option expires.  You can therefore earn interest off of the capital as well as the premium from selling the put option.  You are exposed to the downside in the stock, but if you get exercised, you are also exposed to the upside in the stock.  Your risk profile looks like that in Figure 2, assuming you are exercised and then come to own the stock. (Note: I realize your portfolio’s distribution of returns will look different from the distribution of returns of the stock, since there is a probability of getting assigned the stock that comes into play, but it is not necessary to go into such a detail for the purposes of this exercise).

Now, let’s look at another scenario where you sell a call.  One of two things happen again: 1) you get to keep the premium and are not exercised, so you do not sell your stock, or 2) you get to keep the premium and are exercised, and now sold a stock you want to sell.  In both cases, the capital is tied up in the stock, so you are not free to use that capital to purchase treasury bills as in the case of a put.  You might also miss out on dividends in the stock if the call holder exercises early.  However, in both cases, you have now limited your maximum possible gain in the stock, but you are still exposed to the downside in the stock.  Your risk profile now looks like that in Figure 3 for owning the stock.

Do you see the big difference between selling a call and selling a put from Figures 2 and 3?  In the case of selling a put, you have clipped some of the downside, but still have exposure to the potentially unlimited upside.  In the case of selling a call, you have clipped a small amount of the downside, but you have clipped the upside of stock ownership by selling a call.  Your gain is now reduced from potentially unlimited to something very limited (and likely somewhat close to the current trading price of the stock based on how options typically get priced).  This is called clipping the wrong end of the risk / reward tail.

This is not often discussed when value investors are talking about selling puts and calls for income.  It is severe enough that you should be extremely picky about selling calls, in my opinion.  You should only sell the call if the mispricing is so severe as to make selling the call worth overcoming this deficit.  This will be a rare situation.  I am often willing, in my own portfolio to sell put options on stock I want to own at prices I want to own it. Further, if the stock I want to own is already at a fantastic price, I will probably just buy the stock outright rather than sell a put option on it to try to further improve returns. However, I rarely sell call options on stock that I want to get rid of – I just sell it outright.

Based on the analysis above, my opinion is as follows on buying and selling options:

Buying a put or call option:

• You should virtually never buy puts or calls as an investment strategy – instead focus on buying or selling the stock where time is on your side
• Buying puts as a hedging strategy – if there is a rare circumstance where you have a position with risk that is too large for you, and for some reason you cannot sell at the moment (such as having most of your net worth tied up in restricted company stock), you can consider buying puts as insurance against loss, recognizing that you will pay an option premium for this and that you should consider the option price as an insurance premium that will be lost once paid. It is generally too expensive to do this for more than a very limited amount of time.
• Buying calls as a hedging strategy – if there is a rare circumstance where your business critically depends on a commodity or stock being at a certain price or below, and would fail if the price rises too high, you could consider hedging with a call, to ensure you can continue with business if prices rise, recognizing that you will pay an option premium for this and that you should consider the option price as an insurance premium that will be lost once paid. It is generally too expensive to do this with options for more than a limited amount of time. For businesses, there are more advanced strategies of hedging that are outside of the scope of value investing that can be explored.

Selling a put option:

• Do not sell put options to collect extra premium if you would want to buy the stock at current prices – just buy it.
• Do not sell put options to collect extra premium if you wouldn’t want to own the underlying stock in the amounts and prices specified by the put options.
• When a stock is still a bit out of your buy range, but you would be happy with it at the exercise price minus the option premium, you can sell the put option.
• When a once in a generation overvaluation in a put option occurs and produces a favorable price for a great company, you can consider selling it, even if the company is already in a favorable price range (probably even in this situation, you will be better off just buying the stock, though).

Selling a call option:

• Almost never – instead just sell the stock if you feel it is overvalued.  Don’t sell a call to collect extra premiums – you will eventually get good companies called away from you and incur capital gains taxes.
• When the call option is ridiculously overvalued at a strike price where you consider the stock overvalued and you are willing to incur the taxes on gains if exercised, you can consider selling it.  You must be well compensated for clipping the wrong end of the risk-reward tail if you are going to do this.  It is almost never worth it, in my view, so even in this situation, you would most likely be better off just selling the stock outright.

Some value investors who have sold covered calls for years might be surprised by this information, but I think you will find that eliminating covered calls from a value investing strategy, is usually best. This is particularly true if you want to practice buy and hold investing, which many studies show is the best kind. You do not want to be forced to sell because of a call exercise. In the next post we will look at one final options selling strategy employed by some value investors, the wheel, and I will tell you why I think it is a very inferior strategy to just buying and holding great companies.