This was published on Margin of Safety Investing a couple weeks ago to help new members understand options a bit better. Enjoy.
"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...
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.
OIC Options Basics (oh, I wouldn't leave you hanging)
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 big risk of blowing your account up. You do not want to destroy your account, so scroll back up, click the links and bookmark them (or at least bookmark this article).
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 commitment.
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 margin, are better. Stick with the basics.
Reminder warning: Option trading requires education. Once again, I strongly recommend the CBOE Learning Center and other resources listed above. If you are not practiced at option trading and want to be, start by paper trading a play money account online. Once you are comfortable, make a few small option trades.
My favorite option trade is to sell a cash-secured put in order to build a position in a stock while collecting income.
When you sell a cash-secured put, you are agreeing to be obligated to buy a stock or ETF at a particular price in a certain time frame if it trades below the agreed upon price called the strike price. The person or entity you agree to buy from pays you a premium in order to accept the risk of possibly having to buy the stock or ETF. In this way you receive income right way for only committing to potentially buy the stock or ETF.
The "cash-secured" portion of the transaction simply means keeping money in cash or money market so it's available to buy the stock or ETF later if necessary. The premium is essentially the return on holding that money in cash or money market. Often you can generate a significant amount of income with this strategy.
Selling a cash-secured put is like setting a limit order but getting paid to do so. Think about that. What makes this strategy work is only selling puts on stocks and ETFs that you'd be happy to own at the agreed upon strike price. Never sell puts because you see a big premium. Sell puts because you want the asset.
I like to build a stock or ETF position by selling cash-secured put options. It is completely up to you whether you do this. However, I highly recommend following the link above and learning about what this income generating, risk reducing trade is all about.
When I build a position, I will generally start with either by selling a cash-secured put or pairing a stock purchase with a selling a cash-secured put. I generally prefer the paired method since I know I'll get to own at least some of the asset I'd like, however, it is tough to do this in small accounts.
Option Trading: Buy LEAPs
Once again, visit the CBOE website for educaiton on options.
LEAPs are long-term call options on a stock or ETF. That means we have the right (but not the obligation), to buy a certain stock or ETF at a certain price in the future. These options are long-term in nature and generally expire at least one year into the future and upto about two-and-a-half years.
This strategy is aggressive. It is designed to be used for 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.
An example of when this strategy was extremely effective was in the spring and summer of 2009 after the financial crisis had bottomed out. People who bought LEAPs on the SPY or QQQ stock market ETFs did much better than people who just bought SPY or QQQ. Why? Because they were able to buy the options for a fraction of the price of the ETF and hold long-term as those indexes soared in value.
This strategy is ideal for periods after a stock market crash and when the economy is expanding out of a recession, i.e. like 2009. We should keep an eye out for the next opportunity to take leverage on the stock market. If we allocate some of our money to LEAPs we can very lazily make a lot of money as the Federal Reserve and government stimulate the economy back to good health.
Selling Covered Calls
A strategy that many people use, incorrectly, in my opinion, is selling covered calls too often. My major beef with this technique is that investors often cap their gains by selling calls on a stock or ETF well before it is likely to stop rising. Those investors fall in love (an emotion!) with taking small amounts of income and miss opportunities to make huge capital gains.
I like to let me winners run. It is the occasional big winner that will really turn your investment returns higher.
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
While I will sell covered calls on a partial position when the RSI crosses 70, Chaikin is falling and an asset appears overvalued, it is not a transaction I make a lot.
When it is time to hedge a portfolio, buying puts on an index, asset class or group of stocks can be very effective. This is not something that should be done very often though as the markets and most assets generally rise in value over time. It is rare that buying puts, similar to shorting, is a good strategy for anybody, including professional short sellers.
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.
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-dated call known as a LEAP.
I use this strategy for stocks that I believe have a lot of upside, but also significant volatility. I will take a small LEAP position, maybe 1/2% or 1% of a portfolio, and then I also sell a cash-secured put for a just a touch more of the portfolio. Both puts are slightly out of the money respectively.
In some instances, the put option results in my buying stock. I am okay with that because I like the company in the first place. After a rally, I will often sell a short-dated covered call to generate further account income.
In taking this approach, I get long exposure to an idea, as well as, generate portfolio income. The chart above shows how you can ebb and flow trade.
I have used a synthetic long strategy on many of my higher growth ideas. In several cases, over a number of years of maintaining the LEAP exposure, but also trading cash-secured puts, stock and covered calls on a company, I have generated huge income and capital gains.
This approach is viable for your very best ideas, particularly the ones that have some volatility, but a long-term uptrend.
Nobody's Perfect and Volatility
No service is perfect. Even though my public track record is very good (see TipRanks), 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 working to make a series of good decisions over time while systematically 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 — farriskier 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
Get the point?
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. That is a copout.
There are easy ways to remember options concepts and apply them. One way to think of options is to not think about the stock component. Think about options on real estate. Think about options like insurance. Analogies are good ways to think things through.
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. It might not happen that way, but very often it does, so long as you control your emotions, manage your position sizing, don't act scared and don't get greedy.
See you in the chat, but not until after you've read up.
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Disclosure: I am/we are long XOP.
Additional disclosure: I own a Registered Investment Advisor -bluemoundassetmanagent.com - however, publish separately from that entity for self-directed investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.