Option-Charged Savings for Current Market Conditions

Many investors still perceive options as instruments which are used for outright speculation on the direction of a certain underlying value, with the opportunity to make fast and large profits, but also the chance to lose the initial investment as fast, or even faster. This is particularly the case when an investor weighs the alternative outcomes between, for example, an investment of $1,000 in 20 Wal-Mart (WMT) shares or the purchase for an equivalent amount of 4 call options expiring in April with an exercise price of $50, which currently have a price of about $2.50 per option.

When on the expiration date the share price of Wal-Mart has increased to $55, profit on the shares position will be $100, while the options will have doubled in value. But if the share price has not increased to a level above $50, the whole investment in options will be lost.

click to enlarge

This is just one way of using options; in truth, there are many ways in which options can be utilized while defining investment strategies. It is even possible to construct risk-free options positions, where the return should be equivalent to the return on a risk-free cash instrument. In practice this is not easy, since investors have to pay transaction costs, but mainly because of the fact that part of the advantage will be lost due to the spread between bid and ask prices of options.

If there is a choice between highly speculative positions on one side and risk-free positions on the other side, it must be possible to choose a position between these extremes that corresponds with the risk/reward expectations of an investor at a given time. However, it needs to be clear that it is not possible to achieve additional returns without incurring additional risks. Every investor has to ask himself always if certain risks are acceptable, and if the compensation for accepting these risks is adequate. The interesting thing about using options is that in principle almost every view on a certain underlying value can be translated into an investment strategy.

The possibility to sell put options in order to increase the return on cash positions will be discussed here. With this strategy the risk must be accepted that on the expiration date the underlying value must be purchased at the strike price. Under the present stock market conditions this can be an interesting strategy, since there are already so many negative expectations in share prices. The major indices are substantially down from the levels at the end of 2007, and this has been accompanied with a sharp increase of option premiums. The compensation for absorbing negative share price risks has increased, while the chance that we have come closer to the bottom may have increased.

With this strategy I prefer to choose shares of companies with a solid long term performance and a good dividend yield. In case shares with these characteristics have to be purchased through exercise of the options, there is a reasonable chance that at the price level at which the underlying shares must be purchased, they are a good long term investment.

As an example I have chosen Wells Fargo & Company (WFC), which is considered to be one of the stronger banks. It is also a major holding of Berkshire Hathaway (BRK.A), giving it the support of investor Warren Buffett. At the time of writing the share price of Wells Fargo was $32.60, giving it a dividend yield of about 3.8%. The table below shows how the achievable returns relate to the chosen strike price of put options expiring in January 2009.

In the most cautious scenario, put-options with a strike price of $15 could be chosen. When an investor sells these options, he runs the risk that on the expiration date in January 2009, shares must be purchased for a price of $15. Compared to the current share price this is a discount of 54%. An amount of $14.76 needs to be invested in order to have this $15 available at the expiration date. The option premium contributes $0.65 while the investor must add $14.11 from his own funds. This amount is more than adequate for any margin obligations on the short position. On the expiration date in December it is possible that either the investment with accrued interest of $15 is fully available again to the investor, or that he is obliged buy shares at a strike price of $15.

When the share price is above $15, the investor will keep his money and he will have achieved a return of 6.3% in about 10 months, which is 7.6% on an annual basis. This is a substantially higher return than would have been achieved with just keeping the cash holdings invested in money market instruments. In case the share price has fallen below $15, the investor must purchase the shares, and may achieve a dividend yield of 8.3%, when dividends have not been adjusted. This is well above both cash returns, and the current dividend yield.

When a strike price of $20 is selected, the annual return can be increased to 10.3%, while a price decrease of Wells Fargo shares of almost 39% in the next 10 months is still acceptable, without jeopardizing the calculated return.

An even higher strike price can be selected, with the possibility of higher returns. The vulnerability with respect to price movements of the underlying shares will however become much greater, and therefore also the chance that a price decrease of the shares will lead to a forced purchase of the shares through the exercise of the put options. For an investor who is actively looking for a good entry point for purchasing the shares this may be attractive, aided by high option premiums. For an investor who is seeking additional returns with moderate risks, these higher strike prices will most likely be less attractive.

Disclosure: None

Comments

[bill d]

Great, great article !!!