“You never have played poker before, you say,” says the gambler.
“Well, the best way to learn is to jump right in and give it a try,” he encourages. “Sit right down here at the table, you’re smart, you’ll figure it out.”
Person who never played poker before sits down at the table and takes out his wallet… you know how the story ends.
If you haven’t done significant studying about options before using these investment contracts, then you are the sucker at the table!
The Basics of Options
I am not going to try to teach you the basics of options. You are going to learn those on your own by reading and practicing in a paper account. Here are some core resources that you should spend a few weeks reading, reviewing and studying. In addition, your online broker should have some good resources; if they don’t, you’re at the wrong online broker.
- CBOE Options Institute
- A Guide To Investing With Options
- OCC: Characteristics & Risks of Standardized Options
- Options Industry Council: Options Strategies Quick Guide
- Fidelity: Learn About Options
- Schwab: Understanding Options
- Interactive Brokers: Options Courses
If you cannot be bothered to read and practice on your own time, then do not ask me any questions and don’t ask questions in the chat because I will taunt you and instruct others to taunt you as well.
Please, really, if you aren’t going to study options before trying to use them, then buy ETFs and stocks. Good asset allocation with ETFs and stocks will go a long way to building a market-beating portfolio that takes less risk than the S&P 500.
If you do try to use options, but choose willful ignorance and cannot be bothered to study up first, then you are at big risk of blowing up your account. You do not want to destroy your account, so scroll back up and start clicking the links. Also, bookmark this article, so you can come back to study this piece or the linked resources.
I am completely serious when I say that you can ruin your portfolio by not using options the right way. And you will not use options the right way if you don’t study first. Have I made my point?
If I haven’t discouraged you by now, then read on, and I will help you understand why to use options.
Making Effective Use of Options
Robert Kiyosaki of “Rich Dad, Poor Dad” fame is a big proponent of using options. The main benefits are to cut risk by limiting losses, generating income and gaining leverage on high reward opportunities.
When used properly, options are far safer than using purely stocks and ETFs. Why is that? There are several reasons. Depending on the type of option contract you choose to buy or sell, you can generate income, hedge, build a position at a discount or take leverage on a good idea with a lower dollar amount at risk.
There are many types of combination option trades. I make very few of those, except for one which I will describe below. In general, a lesson I learned over the past 20+ years is that usually simpler transactions never with marginare better. Stick with the basics.
Selling Cash-Secured Puts
Above you read “build a position at a discount.” That is at the core of my favorite option trade which is called selling a cash-secured put.
When you sell a cash-secured put, you are obligated to buy a stock or ETF at a set price in a certain time frame if it trades below the agreed upon price, which is called the strike price.
When you sell a cash-secured put, you get paid a premium. In return, you agree to buy a stock if it is below a set price at that set price.
For example. If I sell a cash-secured put on AT&T with a strike price of $30, expiring the 3rd Friday in June, then I am obligated to buy AT&T shares for $30 if it is trading below that price.
I receive money for agreeing to that, called a premium from the person or entity buying the put from me. They are either speculating on AT&T falling in price or insuring a position in AT&T stock that they have.
For my part, I’m happy to buy AT&T stock at $30 per share and I like that instead of setting a limit order to buy at $30, I can in essence get paid to wait to buy it at that price.
The true beauty of cash-secured puts it that when a stock you want gets beat up on price, volatility rises, making the put premiums higher. That means, you can get paid well to buy low.
What really happens in those situations, is that people are buying insurance frantically or speculating on deeper drops in price. That drives the price of the options up and you can do well being the seller.
The risk is that sometimes, you will buy a stock for a higher price than the difference between the strike price and the premium you received.
For example, let’s use AT&T again. Suppose T drops to $22 per share come June and you received a dollar for that put. In this case, you still have to buy for $30, which minus the dollar you received, making your net cost $29/share, despite it trading for $22.
The take away lesson here is that you have to do good stock research and use some technical analysis to know when to sell a cash-secured put. It’s not some magical system. It’s a way to leverage your judgment and add income as a margin of safety when done well.
Selling Covered Calls
A normal consequence of owning stocks is that sometimes they go up in price because of the madness of crowds. That is, the stock price gets far ahead of what is deserved based on fundamentals.
In these cases, trimming some stock and selling a covered call can make sense. You only want to do this on stocks where outright selling is not advisable.
For example, let’s continue to use AT&T. Suppose you own T and it goes up to $38/share, but you know that’s to high for the next year’s earnings. You might be tempted to sell, but you like it long-term because of the fat dividend and long-term growth potential.
In this case, you might sell covered calls against part of your position when the stock is overbought. This allows you to collect a premium and only sell if it continues higher or stays high.
Here, I will say, covered call selling is a strategy that many people use, and use incorrectly, in my opinion. People believe that they should buy a stock and immediately sell a covered call. That is wrong if you are actually trying to make money on your good investment ideas.
In short, you want to ride your winners. Selling a covered call is only advisable when a stock you own is overbought on a long-term time frame chart, i.e. measured weekly or monthly, not daily, as most RSI charts are measured.
Don’t ever forget this:
All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out. – Peter Lynch
Therefore, you only want to write a covered call if you are less likely to get called away, i.e. the stock is going to stall out on rising.
The Option Selling Cycle
There is an ebb and flow for option selling. It is at the heart of our Retirement Income Options strategy. Here is the cycle you should know and embrace.
While most cash-secured puts expire without being exercised, sometimes they are. You also buy stock outright without options. When your stock rises, you will sometimes trim your positions and/or sell covered calls.
When you get called away or have cash from selling, you will return to buying shares or selling cash-secured puts when the markets are on a correction.
This slow handed patient approach can add at least several points per year to your total returns and reduce your risk because you are periodically, NOT systematically, bringing in cash and setting some limits on your equity purchases.
Buying LEAPs Or Calls
Buying calls is a way to leverage your money and control position size. Most people use calls to speculate and “hit home runs.” Call options actually came into being as a way to manage the size of your commitment to a position and not overextend. Rampant speculation by amateurs hoping to get rich quick has changed that in today’s market.
While there are occasions to use call options, they are far more rare than the trade volume would indicate. Most call options expire worthless and are not worth the risk that the calendar will run out on you.
Many investors feel that one way to put the calendar on your side is to buy a long-term call option known as a LEAP. These can last for years. But there is a big problem with LEAPs, they are very expensive in most cases.
In general, we don’t want to buy LEAPs precisely because of the time value we are forced to pay for. In most cases (not all), it is better to own the stock. That way, as the calendar pages flip, you are not losing value on your position due to elapsing time.
Buying LEAPs is an aggressive strategy. The only real time we use it is on those occasional large stock market sell-offs, or sell-offs in a stock, when we want to take leverage on a rebound or on growth. I have done this precisely 4x in my 25 year career on the broad market and only several times on individual stocks.
If you truly believe in a stock and want the leverage of calls, then buy shorter-term calls into known catalysts, i.e. earnings or announcements and roll them as necessary. This is will be cheaper than buying LEAPs almost all the time and still give you the leverage on your idea that you are looking for.
Remember, the stock market goes up about three-quarters of the time.
Buying puts is a way to bet against the stock market or particular stocks. So, buying puts to hedge or speculate, is something to be very selective with.
When is it time to hedge a portfolio or speculate on a decline in stock prices? There are a few things that must line-up:
- The market or security must be overvalued, generally by a lot, not just a little.
- The market or security must be overbought, generally based on weekly or monthly charts.
- Liquidity can not be too loose, i.e. don’t fight the Fed. If speculation is rampant and it is enabled by easy money policies, you need to wait for the easy money policies to tighten up a bit.
Buying puts on an index, asset class or group of stocks can be very effective. But, it can also be very damaging. Remember:
The market can stay irrational longer than you can stay solvent.Old Wall Street Wisdom
On the rare occasions we buy puts, we want to have a specific time frame for our thesis about volatility or falling asset prices to be right. It is very easy to bet against the markets too early as price trends can be irrational and very long lived.
Being early, is essentially being wrong. In general, I do not recommend speculating with buying puts. Rather, use these tools to insure your portfolio when you would like to hold onto other equity holdings.
Synthetic Long Position
A synthetic long position sounds like an intimidating thing, but it’s really just combining two of the trades above: a cash-secured put, with a long call position.
I use this strategy for stocks that I believe have a lot of upside, but also have significant volatility. The volatility makes option premiums attractively high in this case.
The trade begins when I will take a starter position in a stock, maybe 1/2% or 1% of a portfolio. I then sell a covered call on the position, slightly out of the money to generate income and book myself a profit if the stock rises in the short-term. Finally, I also sell a cash-secured put slightly out of the money for a just a touch more of the portfolio.
The ending set of transactions looks like this:
- Starter position in stock.
- Covered call (received premium)
- Cash-secured put (received premium)
In some instances, the put option results in my buying more stock. I am okay with that because I like the company in the first place.
In other cases, the stock gets called away and the put expires. That’s a winning stock trade with extra income. In these cases, I will look to reenter the stock position with similar trade in most cases, i.e. starter position, sell a cash-secured put and maybe another covered call.
This approach is viable for your very best ideas, particularly the ones that have some volatility, but a developing long-term uptrend.
Nobody’s Perfect and Volatility
No service is perfect. I have made mistakes, often being early or late to the party. That is the life of an investor. We do not seeking perfection; we just work to make a series of good decisions over time while always managing risk.
Remember, volatility is normal. Learn to benefit from it. Volatility is where you will find your best opportunities. It is where you can buy low to create a margin of safety.
“Volatility caused by money managers who speculate irrationality with huge sums will offer the true investor more chance to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times” Warren Buffett
This great emphasis on volatility in corporate finance we regard as nonsense” Charlie Munger
“Opportunities to purchase what we deem to be attractively undervalued companies occur more frequently when stock prices are volatile.” Chuck Royce
“We steer clear of the foolhardy academic definition of risk and volatility, recognizing, instead, that volatility is a welcome creator of opportunity” Seth Klarman
“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.” Warren Buffett (again, and again, and again here).
“If you make more money when you are right than you are hurt when you are wrong, then you will benefit, in the long run, from volatility [and the reverse]” Nicholas Taleb
“Pick any Company you want – the price is very volatile over short periods of time. It does not make sense to me that their values are nearly as volatile as the prices and therein lies what should be a great opportunity” Joel Greenblatt
“You can get lulled to sleep when markets haven’t been volatile, which likely means it’s time to take some chips off the table” Kevin O’Brien
“The true investor welcomes volatility” Warren Buffett
A Starting Point
Hopefully this serves as a good primer for trading options with us. Only study and experience will help you truly maximize your ability to build your portfolio, so start with the study.
One thing I will warn you about is becoming flummoxed by terms and the ideas around options. I have heard people say they cannot wrap their mind around the concepts. If you can’t learn the terms, you can’t trade options.
The language is important to keeping the ideas straight in your head. Take the time to learn before risking your money.
If you become comfortable enough to use options in your portfolio, I make you only one promise: you will have a chance to beat the markets by a lot over time with lower risk. But, it’s a long hard journey. Are you ready?