Thursday, March 15, 2012

Options – cash generator or money loser? Conclusion

Buying an option gives the owner the right to do something or not. Selling an option creates the obligation for the option writer to do something as promised in return for the option premium. The option premium is set in the market through a continuous process of asking and bidding until market participants agree on price and execute the option trade.

The option gives the right to sell (a put option) or the right to buy (call option) an underlying asset such as a share in a publicly traded company for a specific price (strike price) at any time during which the option is valid (term of the option). The value of the option comprises three major components – the time value, the extrinsic value and the intrinsic value. Time value decreases upon approaching the option’s expiry date. The intrinsic value is the excess (in case of a call) or shortfall (in case of a put) between the underlying asset’s market value and the strike price. The extrinsic value is determined by a combination of factors such as the historic and current (implied) volatility of the underlying asset’s market price and the proximity of the strike price to the current market price.

Options are traded in contracts like shares are traded in lots. Although lots are not consistently sold as a whole (100 shares), option contracts are always traded as a package of 100 options – one option per share. The option price is quoted as that of a single option, yet the contract represents 100 options and the contract price is 100x the quoted option price. Commissions charged by full service brokerages are typically too high to make option trading worthwhile for the retail investor. The rise of the discount broker and on-line trading has changed this. Their commissions are a lot lower and on-line trading speed and data access allows the investor to respond nimbly to changing market conditions.

Option trading is not for the faint of heart, speculation and a good understanding of probable trade outcomes is required. Many recommend ‘covered call selling’ as a conservative strategy for the small investor that helps to increase cash flow at a limited risk. However, the real risk is the capped upside for shares that underlie the options. Often share prices do not increase gradually but rather they increase in sudden bursts of price volatility both to the upside as well as to the downside. Typically most share price increases result from those volatility bursts and the covered call writers often miss out on a large portion of this upside. This is especially true during bull markets.

The successful option trader has to actively manage his/her trading portfolio which should be supported by a strong cash position or a significant line of credit. This because the trading involves various option trading strategies as well as the possibility of buying/selling and holding the underlying stock on a moment’s notice. To provide an impression as to the amount of cash or credit that is needed, consider the following situation:

A portfolio sold 2 put option contracts for TD Bank and 5 put contracts for Royal Bank (RY). If both options are exercised simultaneously, the option writer has to buy 200 TD shares (currently trading around $80 per share) and 500 Royal Bank shares (currently trading at $58); that is $16,000 plus $29,000 = $45,000. Considering that most retail brokerage accounts are often less than $30,000 in size such a commitment is beyond the reach of many small investors.

Yet, even when you are not ready to trade options, understanding them and ‘play trading’ options is highly instructive for many investors in learning about stock market risk. Stock market risk is often expressed in terms of standard deviation or the VIX (Volatility Index). Long term stock market studies such as the earlier discussed ‘What works on Wall Street’ by O’Shaughnessy expresses market risk mostly in terms of standard deviation (S.D). O’Shaughnessy’s S.D. is calculated for share price data stretching decades if not nearly a century. Bull and Bear market cycles represent price variations over 4 to 7 year time spans and their S.D. is quite different. When trading options, the S.D. patterns of share prices for the last 90 to 180 days are considered.

Using our trusted RY example, the S.D. of this bank’s shares over the last 100 days (roughly 3 months) has been 7% and average annual appreciation over those 3 months was 79% (or 6.5% per month). If the average share price over the last 3 months was $50.81 then a month from now, the average share price would likely be 6.5% higher plus or minus 7% S.D. That means the share price is likely to vary between 50.81-7% = $47.25 and ($50.81+6.5%)+7%=$54.11+7%=$57.90.

Thus, it would be highly likely that a put with a strike price of $47 would not be exercised within the next three months and neither a call with strike price of $58.00. Of course, this is based on the premise that market conditions that prevailed for the last 100 days do not change in the coming 100 days. Do you see the problem?

My simulations indicate that the risk of a call option being called in a rising market is too high when compared with the costs of missing out on that key burst in appreciation. In such a market you make more profits just by buying and holding the stock. In a falling market, the chance of not exercising the call option is much better and here, selling covered call options are a good way of adding to your cash flow – one of the most important things you can do during a correction or bear market.

Selling put options creates cash flow at the lowest risk during rising markets, but you need a lot of credit or cash in case you get exercised after all. In falling market you do NOT want to sell puts because they are very likely to be exercised and you would be losing hand over fist.

Finally, if you buy very cheap call options (say for less than $0.25 per option) for a typical $50 bank stock in a rising market such as today’s, you may lose your premium several times (i.e. lose 100%), but you’re likely to hit the jack pot a couple of times as well and profits are often 5 fold or more on the original option price making up for past losses and then some.

Combining option strategies, short term holding shares and collecting 3 months worth of dividends plus a decent sized stash of cash or line of credit is definitely profitable. On the borrowed money invested my ROI averaged over the last 3 months 12% or 48% on an annual basis. Since the money invested was borrowed the ROI is in fact infinite. Still, in terms of absolute money value and time spend the profits were not enough to make a living as a day trader. In fact, having a real job is much more reliable, less risky and much better for your health. It took me months to design a trading system that meets my risk tolerance and many trading mistakes. I have traded options on and off now for years. Mostly call options that teased me in trying more and then hitting me with a significant loss over and over again. During the last three months, I have traded options much more frequent than normal and yes it was profitable. But remember my little ‘Buy & Hold Low PE plus Moderate dividend’ portfolio that was started in January? Well that made me quite a bit more and we’ve not even finished the year. An update on that portfolio will be done near the end of this month.

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