Following on from my earlier post about the dangers of owning put options without owning the stock, I would like to summarize some of the different arguments for using one vehicle over the other.
General Advantages of Stocks over Options
- Stocks are easier to get right — For stocks you just need to get the direction right, while for options you need to get 3 things right: the direction (call or put), timing (expiration date), and magnitude (premium). If you are buying stocks on margin, you would also need to get the timing and magnitude right.
- Losses are typically a smaller % of amount invested — The leverage of options magnifies your losses when the position turns against you. In the worst case, you lose 100% of the amount invested. Whereas for stocks, you would rarely lose your entire principal invested. Of course this is balanced with the fact that you need to invest a much larger amount using stocks compared to using options.
- You can wait out a losing position — With a losing stock position, you can average down and hold it over many years for it to recover to fair value. With a losing options position, the expiration date is usually short-dated, so even if you keep ‘rolling over’, you can keep losing your premiums as you wait.
- You don’t get screwed in a stock halt — Options on a stock that is halted during expiry may have problems getting exercised. Put holders may find that there are no stock to borrow to exercise the puts, and call holders may find that the other broker cannot deliver the stock as they cannot buy it in during the trading halt. Hence these options may expire worthless. For more information, read Page 34, item 5 of this.
General Advantages of Options over Stocks
- Potential cheap insurance — You can potentially buy cheap insurance on your stocks/portfolio with deep-out-of-the-money puts.
- Gains are boosted — The leverage allows you to lever up your gains.
- You can control much larger positions, or many more positions — You can enter into much larger positions (i.e. control many more shares) with the same dollar amount, but this is highly risky and can wipe you out. Alternatively, you can control many more positions than you could have done with stocks, since each position costs less to enter into.
- Leaves more cash free – Using options allow you to tie-up less of your capital, which can be kept in cash and used if the stocks tank. Even if the cash is used to buy bonds, you are utilizing that cash to make more compared to tying up that cash in the stock.
- Losses willing to be absorbed are determined upfront — Calls and puts allow you to limit your losses to the premium paid, but that is a 100% loss on the amount invested.
- Not subjected to buy-ins and shorting fees — If you short a stock, you might be subjected to hard-to-borrow fees and interest charges (can be as high as 200% p.a. on the dollar amount shorted), and you might get buy-in warnings/notifications if the stock gets recalled. You don’t have such problems with put options.
Warnings on Using Options
- Do not buy options expiring in the same month — It is human nature to be too optimistic and too confident of one’s short-term prediction ability. Almost always you would end up losing money.
- Hard to win with short-dated ATM/OTM options — It is very hard to win with short-dated at-the-money or out-of-the money calls. Stocks often do nothing unless there is a clear catalyst coming up, even then it would likely be priced into the calls.
- Illusion of cheap ATM/OTM options — The small dollar cost of at-the-money (ATM) or out-of-the money (OTM) options can give you the illusion that they are good buys because you think your downside is well limited. However it is very tough for the stock to go beyond even that small premium in a short period of time. And if the stock goes against you, the entire value evaporates.
- Trade-offs with long-dated options — While long-dated options give more time for the trade to work out, you are paying more for the time value of the option.
- Put insurance often fail — Many times people buy puts to insure against a long position after it has already gone down, or when the stock is already known to be highly volatile. By that time the insurance is too expensive, and the stock usually has not much more to drop. If you are in that position, it is better to just sell the stock and exit the position. Jim Cramer in his book “Getting Back To Even” noted that “.. almost every single time I bought a put to insure a stock position I didn’t like, I lost both on the put and the common stock.”
- Limit your trade size — If you would have allocated 10% of your portfolio for a stock position, you should not be using the 10% to buy options to end up controlling a much larger number of shares. Instead you should buy options to control the same number of shares you would have controlled if you bought/sold using stock. In that way, your downside and upside remains the same (compared to using stock) but you would have a stop-loss on your position.
Deep-In-The-Money Calls vs. Long Stock Position
- Using deep-in-the-money calls gives a good balance between holding the stock long, and using options as a vehicle. While you are risking more dollars on the downside (compared to ATM or OTM options), you still make 1-for-1 gains when the stock moves up, and you minimize losses if the stock did nothing.
- Deep-in-the-money calls can be “rolled over” to the next expiration month by selling and buying it back for the next expiration month. Essentially you are paying incrementally for the time value each month + transaction fees compared to paying for the time value of 1 year at one shot for a long-dated option. Note that the more volatile the stock, the higher the “roll over” cost due to wider bid-ask spread.
- The deeper the call is in-the-money, the less time value you are paying, and the more it trades like a stock. The reason the “time value” is less is because as you go deeper into the money, the premiums increase, so there will be less people buying the option and bidding the price up.
- The strike price of the deep ITM call establishes the particular stop-loss for your position. The relationship between an option trade and a stock trade in this case is this: assuming that your option trade is for the same number of shares as what you would have done for a stock trade, then if you own a call option and the stock tanks, your overall position is as though you have liquidated your stock position at the strike price.
- Buying deep ITM calls for expiry the next month is a good balanced bet.
- One warning is to avoid calls on stock that have high volatility resulting in even deep ITM calls having high premiums on top of the intrinsic value. Jim Cramer would not pay any premium above $5.
Deep-In-The-Money Puts vs. Short Stock Position
- Works the same way as a deep ITM call for a short stock position.
- This is a bet on the stock going down, not as an insurance.
Locking in an Option Profit While Benefitting from a Stock Move in the Other Direction
- While you can lock in an option profit by selling the option, another way to lock in the profit is by entering a new offsetting position in the stock and hold them all to expiration. E.g. short the equivalent number of stock if you have ITM calls, or long the equivalent number of stock if you have ITM puts.
- For ITM calls, if the stock stays at or above the strike price, your profit remains the same. However if the stock drops below the strike, your profit increases due to the short stock position.
- For ITM puts, if the stock stays at or below the strike price, your profit remains the same. However if the stock rises above the strike, your profit increases due to the long stock position.
- If you short the stock doing this strategy, and you are a large enough customer with your broker, you may be able to get your broker to pay you interest on the cash obtained from shorting the stock (i.e. a “short interest rebate”).
- Note that when the options get auto-exercised at expiry, the fee your broker charges for exercising options is typically higher than the commission fee for selling the option.
Advantage of Long-dated Options (or LEAPS)
- One advantage of using long-dated options (e.g. more than 1 year before expiry) is that it naturally makes you think about what the stock price would be by the time the option expires (which is 1 to 2 years or more down the road). This forces a longer-term thinking which is the right kind of way to be thinking about buying stocks.
- No doubt you can also adopt a long-term view when thinking about buying stocks, but because there is no “expiry date” attached to the stock, coupled with the fact that the daily fluctuations of the stock market really messes up your thinking, the natural tendency and result is that you tend to not think long-term when buying/selling stocks. Hence LEAPS help to enforce a more proper mindset.
- What we want to look for are options that are i) long-dated, ii) reasonably priced, iii) as deep-in-the-money as possible, iv) with strike prices that you are very confident will never be breached such that the option value goes to zero.
- The degree by which an option is in-the-money affects a few key factors:
- Leverage: The more deep-in-the-money >> the more expensive is the option premium >> the less number of options you can buy >> the less leverage you get
- Sensitivity to the stock price movement: You want options where the option premium is highly sensitive to the stock price changes (i.e. you want high delta). Really deep-in-the-money options have delta of 1 (i.e. the call option price goes up by $1 when the stock price goes up by $1), at-the-money options have delta of around 0.5, and of course of deep-out-of-the-money options have delta of 0 (you can see a good chart here). The bad thing is the higher the delta (i.e. the more deep in-the-money), the more expensive is the option.
- Flexibility: The more deep-in-the-money the option you buy, the more flexibility you have when the stock price tanks further, because you can increase your bet and leverage by switching into cheaper options that are less deep-in-the-money, sort of like doubling-down. If you are greedy right at the start, and you didn’t catch the low turning point, you can be in a lot of pain when the stock tanks, and you have no options left:
- You cannot double-down because there are no cheaper options left. There are cheaper ones, but those have such a high strike that you don’t want to run the risk of the option value going to zero. So long as the strike price is not breached, there is intrinsic value in the option which can be kept alive by paying transaction costs to switch from expiring options to long-dated options,
- You cannot sell because you have already lost a lot due to the leverage, so you need to at least maintain the same leverage as the stock price recovers in order to break even.
- While the longer the time to expiry the greater the time value you pay for, beware of options that are “overpriced”, such that as time passes, not only do you lose the time value, you can also lose the “value above fair value” that you pay for when you buy an overpriced option.
- Always use some form of Option Pricing Model to fair value the options, and compare fair value with the market price. Play around with the inputs (e.g. volatility, interest rate) to get a range for the fair value of the option. An overpriced option has a price that is still higher than your range (e.g. the premium is still higher despite you using a 90% volatility and 10% interest rate). If you buy an overpriced option, it is possible that even though the stock price moves up, the increase in option value is offsetted by the decrease in overpricing (above fair value), since you never know whether the same overpricing spread will still exist at the time you wish to sell your options.
- If you do find overpriced options, it can be a signal that there is a strong demand for those options, and that market players are making their bets using the options market rather than the stock market for fear of impacting the stock price too much. Consider whether it is a better idea to make your bet through the stock market, rather than paying for overpriced options. Other players might end up betting through stocks when options get too expensive, so overpriced options may foretell moves in the stock market.