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Hedge fund manager, value, contrarian
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Summary

  • Options and LEAPS are an excellent way to gain leverage if you know what you are doing.
  • You can use long dated Options to skew Risk/Reward profile in your favor.
  • A real life example from our portfolio to show you how we did it.

Einstein invented E = mc² and it has been used to do some extremely productive things (such as generation of electricity) and some not so productive things, since this formula became known to the mankind. You can read more here about the implications of this formula but my point here is that if man is given a tool, some will use it to their benefits and some to their detriment.

Time Magazine (July 1946 issue cover)

Options and LEAPS ("Long-Term Equity Anticipation Securities") are such tools that have been invented a long time ago and have constructively helped many investors achieve their investment goals. But Options may also be used for speculative and wealth destruction purposes by many, who most likely don't realize the ill effects in their zeal to make a quick buck in the stock market.

Obviously there are so many Option strategies that it could make your head dizzy should you dare to read them all. Thus instead of molding yourself into different option strategies, you should make options help you achieve your picture investment objective. It might be simple for you someone who knows what he/she is doing but might come confusing to the beginners. Whether you are a pro or a beginner the ideas in this article could bring your great wealth, long term. The only catch in this is "long term".

Many self-proclaimed experts and websites that teach options usually encourage option traders to use various option techniques without regard to any investment objective. I would much rather have a firm investment philosophy first and only then have options to "serve" me rather than control my behavior driven by greed. In all fairness, there are many good websites that have very useful information on different option techniques, which can be found here, here and here.

But please remember that although these websites would encourage you to trade options and your broker would be equally happy with your trading activities (as these trades translate into commission dollars for them), I encourage you to use options sparingly and only sub-servant to a clearly defined investment strategy. Otherwise you would lose sight of what you are trying to accomplish and would start to see stock market as a gaming table with potentially "free" money up for grabs.

There are so many option strategies that it's truly impossible to cover them in a single write-up. There are such fancy names for option strategies as "Iron Butterfly", "Christmas Tree Butterfly" and "Fig Lead"… and the list goes on. Therefore I cannot emphasize enough that before starting any options trading, layout a clearly defined investment strategy and only then start to think about which option techniques to deploy in order to take advantage of them. Due to the vastness of Option's field, the options strategies that I have chosen for this article are well suited to my investment philosophy. Thus if you harbor a different philosophy, you should research option strategies that suit your own investment style.

You see, I am a capital gain investor and care much more about capital gains than obtaining premiums or even dividends, so naturally my option strategies are geared towards maximizing capital gains. I am not too concerned if I lose dividends or premium income. For example, when I buy Call options in hopes of capturing capital appreciation, the party on the other side is hoping for something that I don't want, i.e. premiums, dividends, and is return willing to give all upside to me going forward and until expiration. Thus if the price of stock (or index) goes nowhere they can keep everything, their shares, the premium and dividends (if any), while on the other hand, I would like to see the stock go to the moon. What I am trying to accomplish is to have some "skin in the game" without betting the farm. Thus if the stock loses half its value during option's period, I would only lose a relatively smaller amount. On the other hand, some of you could argue that if I were simply long, I could have held onto the stock and "waited it out", which is a valid argument. That's exactly what makes options interesting that they are highly dependent on your judgment and thus makes it even more fun. Thus it is even more imperative to do fundamental research on underlying security and use LEAPS more often in order to give your directional bet some time to work itself out.

Consider this quote from a famous scientist by the name of "Archimedes'"

"Give me a lever long enough and a fulcrum on which to place it and I shall move the world."

When I think of options I think of similarly lifting a large weight that I otherwise cannot lift. That's what I alluded earlier that options should be considered a tool and nothing else in your investment life and tools are to be used sparingly and only on "as needed" basis. But for some investors it becomes a scenario of "tail wagging the dog", while it certainly does not have to be this way. Simply put when I look at options I look at a tool where I can enhance my returns while putting small amounts of money at risk, ONLY WHEN ODDS ARE IN MY FAVOR.

Please read the bold print again as this might be the most important sentence in this article. Otherwise an options trader is akin to someone rolling a dice on a Casino table and hoping to win every time, which is not possible. Well maybe I am too harsh by comparing options to casinos, nevertheless if you don't know the odds of winning, you should stay away as you would be at the risk of losing money. Now I am going to give you two scenarios under which we use options (rather sparingly) at Netwall Investments. Again the use of options is based on our unique investment philosophy so you need to fine tune yours and should not use this strategy as a copy-cat as it might bring bad results for you.

Stealing money "Legally"?

It has been my observation that when people first learn about options, they somehow get this notion that writing options equates to getting free money - until the judgment day (read "market crash") arrives and they are wiped out. An amateur investor once excitedly told me that he had discovered a way to "steal money legally" in stock market? When I asked how, he proudly mentioned using Collars. You can learn all you want to about Collar strategy on the net but in a nutshell this is how it works:

  1. You buy shares of a high dividend stock (money on the line, go long)
  2. You write slightly out of the money covered Call and get premium
  3. You use the premium to buy protective Put to limit your downward loss
  4. You have locked yourself into a sure profit, albeit a small one

So if the stock tanks during your holding period, your Put option covers you while you ensure to offset any loss by the call premium plus dividends that you receive along the way. If stock rises too much, all you have to is to give away all profits above your Call strike, which is just a luxury problem for the call writer. In the meantime, he has received dividends and would make money from capital gains depending on how much out of the money the call was sold.

Now I can see that some of you option newbies might be becoming too excited to discover this scheme of "stealing money legally", but let me remind you that there are no free lunches and options have real costs. Of course you can always protect you 100% of the time but that comes at a cost and these costs could be steep. So for example if you go long and then immediately buy protective Puts at the money, I would question your judgment for going long on the stock. Why are you so unsure about your position such that you had to buy protection? And what are you going to do in the future if stock keeps on climbing up? Keep buying more Puts to create a floor under your feet? Though true that you are limiting your losses but at the same time you are also limiting your potential gains and that's where Options frenzy becomes detrimental.

Typically people who engage in short term Options trades are also subject to short term capital gains which are typically taxed at 35% rate for most people. So "Uncle Sam" is an automatic partner for 35% of your profits that you make anyway. Therefore short-term options strategies might not be too lucrative since you would have to pay short-term gain rate taxes when your capital could have been deployed elsewhere earning tax free returns.

A Hedge Fund manager that I respect and admire, Joel Greenblatt of Gotham Capital, has written a book, "You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits". Though the title of his book is reminiscent of some "get rich quick scheme", actually it is one heck of a read. Furthermore, Mr. Greenblatt ranks very high in the list of great investors in today's day and age. Although I knew about LEAPS (Long-Term Equity Anticipation Securities) for a long time, I always thought it to be a waste of funds (or a potential for waste if things didn't go my way) but then Greenblatt changed my thinking by asking to think in terms of odds. Actually all the great investors I have read about, including Warren Buffett, think in terms of odds, and they only tend to act when odds are in their favor. It made a lot of sense to me and since then these techniques have made a lot of money for me and my clients.

"Peter Lynch" vs. "Nassim Nicolas Taleb":

Unless you are an absolute amateur, I have noticed that people typically have very strong feelings about options. Either they love them or hate them. Usually there is no middle ground. But then some of the great investors that I admire such as David Tepper of Appaloosa Management and Bill Ackman of Pershing Square Capital Management, prudently use options to tilt odds in their favor. Another way to prove to you that options have different connotations for different kinds of investors is using these two famed examples. "Nassim Nicolas Taleb" tells everyone to become an Option's tramp while Peter Lynch never used options to hedge anything in his career. He says that that finding good investments is in itself is so much hard work that he cannot spend any more time (or money) to delve into the options world. On the other hand, Taleb tells everyone including institutional investors to never invest without hedging with options. Particularly he is concerned about "Black SWAN" events (rare events such as financial crisis of 2008/09 that can wipe you out). In my opinion, you should not have such an exposure anyway that a Black Swan can wipe you out. But traders cannot even think of living without options as they have to constantly hedge their bets.

No Free lunch? How about a cheap lunch?

As discussed above, there are myriad of ways of deploying options and all cannot be discussed in one article. However I am going to discuss two scenarios, which will make you money in the longer term, provided that you promise to undertake the basic fundamental research on your chosen securities.

Well I don't think that there are ever free lunches available but the strategy I am going to mention now comes as close to a free lunch as I have ever seen. But you still need to do the basic fundamental research on stocks you put this strategy to work for and be willing to own these securities.

Here is a way to do it:

Writing an out of money Put and buying at the money (or slightly out of the money) Call to cancel out the expense of each other might allow you to reap the gains of a particular security if your fundamental research shows that there are growth catalysts for a particular security in coming 1-2 year time-frame. Although things could be different at times, my experience tells me that typically you have to write double the number of Puts (about 30% out of the money) that would allow to you to buy half the number of Calls, which are at or slightly out of the money with same expiration date, 1 to 2 years down the road. Again premiums could be very different for various securities depending on their volatility but your take away here should be to create a zero debit or as small of a debit as possible in the transaction. But please do not get carried away in the zeal to create zero debit (with higher premium) that you don't give yourself a good margin of safety for writing out of the money Puts. So choose your favorite stock (ideally a Megacap) and look at Options tables with Jan. 15 2016 expiry. Then try to see what number of Puts you need to write and how much out of the money you have to be on those Puts to match a transaction that would net a zero debit after buying at the money Call on the same expiry.

The way I look at it is to consider your small debit (if any) as your initial investment outlay for the profits that you would be reaping in two years. If you do a ROE calculation you will see returns of more than 100% on your bought calls with reasonable upward movement of the stock in two years. For example if you bought at C50 and stock only appreciates 15% each year compounded annually, it should end up around $66, so your profit would be about $16. This could vary but considering you could buy calls for Jan 2016 for around 2-3 range, if you bought one call for $3.50, then your total compounded annual return for two years is going to be 277.96%. This is not a typo guys, this is a real return for taking small amount of risk (depending of course how you define risk).

Case in Point (NYSE:NOV):

Consider this an insider's scoop but our fund (Netwall Investments) has recently created the following positions for NATIONAL OILWELL VARCO for Options expiring Jan 15, 2016.

  1. Sold approx. 30% out of money Puts from current stock price (~$73). (So basically naked Put)
  2. Bought at the money CALL for the same expiration
  3. Created a small debit in the process, which is used below to calculate ROI

So here is our rational. We have done all our fundamental research on National Oilwell Varco . Without going into all the details, we believe that the company is well positioned for the next two years to create a lot of shareholder value and shares do not fairly reflect all goodness that is coming in the near future. (e.g. company is becoming a lot more focused on its core business which would unlock even a lot more value for the shareholders going forward). Thus we believe that the company's shares would end up a lot higher in 2016 from their present price of about $73-74. Sure we are going to miss about 1.5% of dividends that the company pays but we are willing to let go of this dividend for the upward potential of this security. So here is how this trade could play out until Jan 15, 2016.

  1. Shares end up a lot higher than $73: Anything above $73 will be a pure profit for our partners with tax advantage (long term capital gain tax). This is not to mention that the Puts we have written would have also made sizable gains adding to the profits. Let's say that share price of stock gains 15% CAGR, which is a reasonable assumption in our opinion. So in little less than two years (Jan 2016), with 15% compounded annually, the shares would be trading around $95-96 range. This would represent a capital gain of about $23 per share and if we calculate our return on investment (ROI) on the original debit, it comes out to be 256% compounded annually. Yes you read this right, it is indeed 256% compounded annually. Oh… by the way this does not include the gain on our Put position that we would be able to realize due to the fact that stock has gone up. If we decide to call the shares and not sell immediately, we can hold onto our shares and whenever we sell in future, the gains would still be taxed at long term capital gains rate.
  2. Shares fall below the strike of the Puts and we get assigned: Since we have performed all of our fundamental research and due diligence already and since we are happy to become buyers of this stock even at present prices, we would be ecstatic if we could purchase the stock at a 30% discount from today's prices on a company such as NOV. We would hold onto this stock for a long period of time since we believe in the future of this company.
  3. The stock price remains in between strikes of the Put we sold and the Call we purchased: This would be the worst-case scenario for us. Although somewhat unlikely, but this sure can happen if stock falls slightly below $73 and then goes nowhere from there in the next two years. We would lose our debit amount that we paid to create these two positions (plus brokerage commissions, of course). Well, with many upcoming catalysts for this stock, there is a less than 5% chance of this happening.

So looking at the above scenario, there is a caveat for you that your broker will either set aside cash (or use margin against your marginable securities) equal to the Put assignment risk that you have taken. Obviously you could have deployed those funds somewhere else. So there is opportunity cost risk that you need to look at. Thus you could deploy this strategy for your favorite security which is slightly overpriced in your opinion but you firmly believe in the long term prospects of this stock but willing to buy and hold it if drops too much. Also if your marginable securities tank during a market crash, you will receive those painful margin calls from your broker. So be cognizant of these Black Swan events in your investing career and never forget that most likely we are in a bull market already.

Selling Portfolio Insurance:

When volatility increases, premiums tend to increase also. Long-term investors generally do not worry about short-term volatility (even recessions) and they don't expose themselves in such a way (using leverage) that a recession can wipe them out. Also it is proven via various research studies that those investors who are over-leveraged and over exposed tend to make use of options much more frequently than others. They will make several bets and then hope some of these bets will pan out. However, this is not the way to go for a superior investor. Stock market is not a casino and therefore, I sometimes like the idea of European style options, which only allow entry points at expiration thus discouraging speculative trading.

I don't mean to portray that everyone who is looking to hedge with options is making a short term directional bet; actually there are other reasonable uses of different option strategies which are completely legitimate. One reason could be that you might need some kind of floor for the price of security that you are buying. For others it is lure of premium income and dividends and some who consider their long positions "dead money" if stock hasn't gone anywhere for sometime and want to earn some premium on it. The list goes on. If you are planning to write Put options, your thinking should go something like this:

You have done complete research on "XYZ" company and you love this company and would like to own it except for the fact that you think that stock is over priced. You just wish if price of XYZ company would be just 30% less, you would buy a truck load of shares. How about writing 30% out of the money Put options on this security and receiving a premium. Please note that the amount of this premium is going to differ depending on the current volatility of the markets, so it might be that you would not be interested in writing a Put at a reasonable margin of safety under current market conditions when it pays paltry premiums - but this is a decision you will have to make.

Should you decide to write a Put option, three things could happen:

  1. The stock price remains above the strike price and you do not get assigned, in which case you can keep the premium as consolation money
  2. You do get assigned, in which case you would not own the stock at the strike price but actually strike minus the premium received earlier. And your broker is going to lower your cost basis by the amount of premium below strike.

A fellow author on seeking alpha by the name of "The Financial Lexicon" wrote an excellent article on buying those securities or indexes that you think are over-priced and you do not want to buy those at current prices but are waiting for a pull back. But then you are afraid that there might not be a pull back at all and you would still like to make some money. You could sell Puts on the index (I think he cited S&P) but the major drawback of this strategy would be missing a major rally. But many believe that we are in the bull markets and these rallies in major indices might come to a screeching halt at any time.

Automatic leverage from the US Government:

The US Government was given TARP warrants for helping out financial institutions (and some non-financial companies) during recent financial crisis. These warrants are now publicly traded securities and provide an "automatic" leverage without actually deploying leverage. So for example instead of buying Bank of America (NYSE:BAC) common stock ($17.21) there are two warrants available BAC-WTA ($8.20) and BAC-WTB ($0.90). Thus you can see that if you buy BAC-WTA, you are automatically getting about 2X leverage. This article is not intended to go into intricate details of warrants but these warrants provide you with leveraged trades. If you are long term bullish on these financial stocks then you could consider these warrants which are long dated LEAPS but with added sweeteners (For example, AIG warrants expire in 2021). So these might offer a better alternative to LEAPS not only because these have longer maturities but because these warrants have built-in provisions that go in favor of an investor if these companies pay out dividends (remember you are going to miss on dividends if you choose to buy warrants). The provisions are such that the strike price will be adjusted downward by the amount of dividend paid. For those of you who want to investigate these warrants further, I would suggest read many articles written by a fellow seeking alpha author, Adam Jones. One of his recent articles on JP Morgan (NYSE:JPM) can be found here.

Needless to say we are warrant tramps at Netwall Investments. Below are the companies whose warrants are our favorite (Ticker could vary depending on the financial website you are on, or your broker). Please do your own research in buying warrants, since the returns are leveraged, so would be the losses - these warrants are a double-edged sword and don't forget that we are believed to be in a bull market by many measures. Thus if stock prices of these companies start to slip, the downward slide of warrants would even be steeper.

-Bank of America ("Series A")

-Well Fargo (NYSE:WFC)

-AIG (NYSE:AIG)

- General Motors (NYSE:GM) ("Series, A/B/C") (Caution: Series C expires Dec. 2015)

-Citi Group (NYSE:C) ("Series, A/B")

-JP Morgan

- PNC Bank (NYSE:PNC)

-M&T Bank (NYSE:MTB)

Conclusion:

In my opinion, either retail investors do not understand Options and the ones that do are often carried away in use of options and thus become susceptible to a loss. The best way to deploy options is to first take a careful look at the risk and reward and only use options if rewards are tilted in your favor. Also if you are using options to hedge a long or a short position, make sure to understand the fundamentals of the underlying issue. Options are an expensive way to hedge (as opposed to using swaps or derivatives) and hence should be first thoroughly understood and then used sparingly with clearly defined strategies. I have highlighted two strategies that we have used recently for your benefit. If used appropriately and with skill, you can skew the risk/reward equation in your favor, which is likely to increase the size of your wallet going forward.

Notes & Disclosures:

This is not an investment advice. Please perform your own due diligence before making an investment.

This article was written by "Syed Saqib", CIO ("Chief Investment Officer") at Netwall Investments LLC. I don't intend to portray that Netwall Investments LLC is either invested in above securities or going to invest in the future. Investing or not investing in any security is solely upon our discretion and it can change without notice. Furthermore, we can get out of a position at any time as we deem fit. This is our foremost fiduciary duty to our clients who have invested their capital with us.

Disclosure: I am long BAC, NOV, WFC, AIG, GM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: How To Tilt Odds In Your Favor Using Options And Leaps?