As markets become more turbulent and investors are seeking ways to protect profits or perhaps enhance them, call and put options are rising in popularity in an unprecedented manner. Of course, investors are much more likely to shoot themselves in the foot, than do anything productive when it comes to “calls” and “puts” – but we’ve gotten a lot of emails asking about them during the recent market plunge and subsequent rally.
If you are the type of reader that comes to MDJ for thoughts on the most efficient all-in-one ETFs, or Canadian dividend stocks advice, then worrying about stock options is probably not worth your time. To be honest, the vast majority of investors should never worry about these semi-exotic financial tools. That said, we’ve put together some thoughts on the current options environment (as much for education purposes as anything else), as well as some beginner notes concerning what options even are.
It’s being reported that retail options traders on the infamous Robinhood platform are supercharging the very renaissance of stock trading, and are pushing the daily action into new heights. It’s also being reported, or at least speculated, that a portion of these traders are 10-year-olds who play Fortnite. Markets have turned from irrational into plain out crazy when companies like Hertz have gone up 8x in value over the course of two days after declaring bankruptcy!
- THE BASICS: How Call and Put Options Work
- How Put Options Make Sense as Hedging… Sometimes
- Options Selling / Writing
- Best Online Brokers for Buying Options
- How to Write a Covered Call Option in Practice with Questrade
- The Equity Collar – Another Risk Reduction Options Strategy
- Bottom Line on Options Trading
As options are regarded as a “zero sum game” (there are opposing views on this subject), all the turbulence and certainty, topped off by the massive influx of new traders, is luring smart money into options. These smart-money investors who are normally passive in their approach which leans towards long-term index or dividend investments, are now playing the option game, wanting to capitalize on the volatility, and get on the gravy train – perhaps to cover some of the losses incurred in Q1 of 2020.
The following charts show the upsurge in daily option volume between 2020 and 2019:
These options volume charts from the OCC suggest that average daily volume of option trading is up 40% or more YoY between Jan-May 2019 and Jan-May 2020.
We are currently amidst the (potentially) biggest financial crisis over the past 100 years and volatility is at its peak, and that seemed like an appropriate time to collate all the previous stock option trading guides written on MDJ (by myself and Pree, and process them into a one cohesive guide.
This guide will teach you why investors buy put and call options to begin with, how do calls and puts work and how do they differ, what is option writing, how to write covered call options, how to roll a covered call option, and whether you can actually use put options to protect your portfolio from volatility.
THE BASICS: How Call and Put Options Work
The first thing to note is that OPTIONS generally come in two flavours: CALL OPTIONS and PUT OPTIONS. Both of these flavours differ significantly from their distant cousin EMPLOYEE STOCK OPTIONS – which are financial instruments issued by companies to their employees. EMPLOYEE STOCK OPTIONS are an employee benefit that represents the ability to purchase treasury shares right from the company at a specified price for a specified period of time (usually 2 years or thereabouts).
For now, we’re going to focus on the more common type of stock options trading, pertaining to CALL option and PUT option varieties. Options are both a very simple concept, and at the same time, a very versatile and complex portfolio management tool. There are very conservative option strategies and VERY risky option strategies. More press is given to the riskier strategies unfortunately. Every time I explain some simple option strategies to investors, eyebrows are raised and questions are asked… There just isn’t enough information and investor education on options out there.
Let’s begin by talking about Call Options. Options are a type of “derivative” – and a derivative is a security “whose value is derived from the value of something ELSE”. What it means in this case, is that when you purchase a call option on a stock – you haven’t actually bought the stock – but the value of the option that you just bought IS related to the value of that “underlying” stock. I’ll spare you the academia from this point on and just get right to the nitty-gritty…
When you buy a Call Option, you are buying the OPTION to purchase a stock in the future for a set price, for a set period of time. This would be advantageous if you thought the stock was going to go up in the future. Also of note, is that call options provide for a degree of leverage (allowing you to increase your potential returns) and also limit your potential losses.
Let’s examine a typical Call Option quote on the stock ABC, which has a current stock market price of $50:
|Option Type||Security||Expiry||Strike Price||Premium|
Reading from left to right: This quote is for a CALL OPTION on the security ABC. The option contract EXPIRES IN APRIL. The STRIKE PRICE of $55 is what the option holder can purchase the shares of ABC for anytime up until the 3rd Friday of April. To purchase the ability to do this would cost the option holder $2.50 per contract per share.
It’s not quite as easy as a typical stock quote and certainly some quirks too! Probably the thing that sticks out most is that all options expire on the third Friday of the month listed. That means the option holder has the ability to exercise their option up to AND including the third Friday of the month – otherwise the option expires on the Saturday.
The second thing that I want to point out is the “strike price”. If you were to purchase this option contract, you would have the option of buying 100 shares of ABC for $55 per share, no matter what the stock was trading at. Obviously it would make no sense to “exercise your option” and purchase shares of ABC for $55 today when they are only trading for $50 on the open market. If, on the other hand, ABC was trading at $70 before April, you could still buy it for $55 since that is the option you have bought. Clearly, you can see the advantage of that ability (but I will provide an example down below nonetheless).
Thirdly, note that I mentioned the quantity of 100 shares. Each option contract is specified for 100 shares of the underlying stock. So even though the premium (the price to buy this Call Option Contract) is $2.50 – your outlay will be $250 ($2.50 x 100 shares).
Fourthly, when the value of the underlying stock starts trading ABOVE the Strike Price, the option contract is said to be “IN-THE-MONEY”. When the stock price is equal to the strike price, it is “AT-THE-MONEY”. And finally, when the stock price is BELOW the strike price – the option is “OUT-OF-THE-MONEY”.
Option contracts would be used as followed in financial parlance: I own an April 55 Call on ABC.
Practical Examples for Call and Put Options
Okay, so we’ve gotten the semantics out of the way now, so let’s look at some examples of purchasing the above call option contract with three different outcomes:
- Stock goes up
- Stock price doesn’t change
- Stock goes down.
Scenario 1: ABC goes up to $60 before the Expiry Date
In this case the option contract becomes “in-the-money”. Since you could sell shares of ABC in the open market for $60/share – it would make sense to exercise your option to buy the shares at $55/share and then immediately sell them for a $5/share gain. But, that being said, many people don’t actually exercise their option – rather, they just sell the option contract itself. The option contract’s price will fluctuate with the underlying stock’s value – and when the contract is in the money, the option contract’s price rises in lock-step. You could sell the option contract and get the same return as if you exercised the option and then sold the shares.
If ABC is trading at $60/share, then the Apr 55 Call will be trading for very close to $5. Remember you only paid $2.50 for it – so if you sold the option, you will have doubled your money (bought the option contract for $2.50 and sold it for $5.00 = a $2.50 gain x 100 shares = $250 gain). If you did it the hard way, then the math would look as follows:
You bought the contract for $2.50, which multiplied by 100 shares = $250 (cost)
You exercise your option so you buy 100 shares at $55 = $5,500 (cost)
You then sell your shares immediately for the market price of $60 x 100 shares = $6,000 (proceed)
$6,000 – $5,500 – $250 = $250
So the math on doing it either way is equivalent.
If you compare this to the regular method of being long a stock, your gain is not quite so spectacular. You might normally buy 100 shares of ABC at $50 dollars, and then just turn around and sell those shares at $60/share when they appreciate. Your initial outlay would have been $5,000 (100 shares x $50/share). Your sale proceeds would have been $6,000 (100 shares x $60/share). There was no premium paid for any contracts, so that’s it. You would’ve had a gain of $1,000 on $5,000 – or 20%.
Remember though, we have just looked at the “rosy” side of things – you need to weigh the options (pun totally intended) of the various different outcomes as well… so let’s do just that!
Scenario 2: ABC stays at $50 up to the Expiry Date
In this case, the April 55 Call would be “out-of-the-money”. The value of the option would slowly dwindle down to ZERO by the expiry date. The reason it has any value at all during this time is due to the fact that the further away we are from the expiry date, the more chance there is of ABC getting to its strike price. This is actually known as the TIME VALUE OF THE OPTION.
Warning: Tangent Beginning…
Actually, now is a good time to make a segway about the pricing of options. The price of an option is made up of two components:
- The Time Value of the Option
- The Intrinsic Value of the Option.
The Intrinsic Value of the Option is quite easy to calculate. It is simply the difference between the underlying stock’s price and the strike price whenever the option is “in-the-money”. So if ABC were $60 – the intrinsic value of the option is $5. Simple as that.
The Time Value of the Option is a *bit* more tricky. You see, you can’t really quantify the time value of the option in and of itself, but you can figure it out based on the difference between the option contract’s price and the intrinsic value of the option. So if the option contract is priced at $5.50 (when you own an Apr 55 Call on ABC and ABC is $60/share) then you know the intrinsic value is $5 – therefore the time value is $0.50. If you bought the Apr 55 Call contract on ABC when ABC was AT-the-money (i.e. the strike price is the same as the share price) and the price of the contract was $2.50, then $2.50 would be the time value of the option. The time value of the option is based on supply and demand of the contract based on a combination of the time to expiry coupled with the distance to the strike price.
Tangent Over! :)
Okay, so back to our example, if ABC never appreciates (or in other words, never gets to the strike price) then the option contract will expire worthless! That means that you are out the $2.50 contract premium you paid and you have lost 100% of your money or $250 (100 shares x $2.50)!
Compare this to just going out and buying the 100 shares for $50/share and then selling them for $50/share. You spent $5,000 and got back $5,000 (well, I suppose you would be out a few bucks for commissions, but for the sake of our argument – let’s omit commissions for now). In this case you still have your entire principal.
So – all of a sudden, the world of options is losing some of its luster, n’est-ce pas?
Scenario 3: ABC goes down to $40
Well, by now you should realize that unless ABC is in the money by the expiry date of the option contract, the option contract will expire worthless no matter what. So you still have lost 100% of your money by buying the Call Option Contracts in this case. It doesn’t matter if ABC becomes delisted – you can only lose 100% of your money when buying a Call Option Contract.
But for the investor who goes out and buys 100 shares of ABC at $50/share and then sells them for $40/share, they will have lost $1,000 on their initial $5,000 outlay – for a total loss of 20%.
But while a 20% loss sounds better than a 100% loss – in this case the option contract holder only lost $250 while the traditional method yielded a loss of $1,000. So the absolute loss is greater than with the traditional method in this case.
Calls and Puts Explained – Conclusive Thoughts
Okay, so now you have seen the mechanics behind how call options work. I think I have presented a balanced view of how they can work (or backfire) for an investor. So who buys options? Well there are two main reasons for buying call option contracts.
1) High potential leverage – when a stock only has to appreciate by (in the example case) 20% to yield a 100% return on your money – well that’s quintessential leverage isn’t it?
2) Limited risk – Maybe that sounds paradoxical when you can lose 100% of your investment, but consider the absolute value of the loss can be small (the value of the contract purchase) which in our sample case was $250.
If you have a theory or a speculation that a stock is going to appreciate, buying an option allows you to leverage your long position in that stock for a quick and large gain, in theory.
In reality when you are buying a stock option call or put, you are in fact paying a hefty premium and particularly in times like today in which the volatility is at peak as also reflected on the VIX (which measures volatility expectations by measuring the premium rates on puts – if the VIX is high it means that put premiums are high). As of today, taking significant positions will be very expensive to do and while your loss in buying options is capped you still have a spread to beat.
The best way is to explain this concept is with an example. In this case, let’s take a look at the Canadian stock index with the iShares ETF XIU. If you are an ETF indexer, there is a high probability that you own XIU, but how do you use puts to protect it against depreciation in the event of a market meltdown?
Buying Call Options?
Discover Canada’s best online brokers below and avoid overpaying on a derivative which is expensive to begin with.
How Put Options Make Sense as Hedging… Sometimes
Below you can find a simple advantage on how to use put options to mitigate risks (written in 2010, but still relevant today):
If I go to my online stock brokerage, I see that XIU currently trades at around $17.75 (May 17th, 2010). If I go to the options quotation section of my account, I see listings for various XIU put options at specific strike prices and associated premiums. Of course, the higher the strike price, the higher the premium and vice versa.
In this case, say I buy a 5x Sept 2010 put option contracts for $1, with a strike price of $18.00. As each contract represents 100 shares, out of pocket, this means I purchased $500 (5 contracts x $1 premium) worth. If the market does the double dip recession as many perma bears are predicting, XIU would approach the $13 mark. What does this mean for the put option?
As I purchased $500 worth of “insurance”, and the market corrects significantly, the insurance would pay out handsomely. In this example, let’s assume that XIU is worth $13 on expiry (3rd Friday in Sept 2010). What kind of profit would I have?
(Strike price – current stock price – premium + time value of shares) x 100 x number of contracts
As we’re selling at expiry, the time value would be $0. Doing the calculations, it would be:
($18 – $13 – $1) x 100 x 5 = $2,000 (400% return on investment)
In case you’re wondering, XIU would need to close below $17 (strike price – premium) before the Sept expiry in order to be “in the money” or profitable. The investor can sell the option itself at any time before (or on) expiration without purchasing the underlying shares (as most do).
What is the risk? If the markets are higher (or around the same price) by the time expiry rolls around, you’ll lose 100% of your option investment, or $500 in this case. However, is that a bad thing? It simply means that the underlying index is still strong, and that your insurance was not used.
Current Example – Options are EXPENSIVE in 2020!
Let’s take a practical example from June 20, 2020, for SPY (SPDR S&P 500 ETF). Let’s assume you think that by Jan 15, 2021, the market will drop. You are either trying to defend your long portfolio by betting in the opposite direction, or simply making a speculation. The current SPOT for SPY is 308 (exactly 10% of the SPX), and you think it will drop a hefty 20% by then to 277. So you buy put options for a 277 strike for Jan 15, 2020.
A single option will run you $17.56 and one contract consisting of 100 options will cost you $1,756. That means that you only start earning when SPY drops below 260 points (deducting the spread cost from the actual strike)… and even if that happens, a single contract isn’t going to defend much of your portfolio! Even if SPY drops to 240 which is a very drastic scenario, that contract is only going to net $2,000 in profit (or $3,756 in total return, which includes your initial costs). So to protect a sizable portfolio you will need to buy a good number of such contracts, and that capped/limited loss concept is voided because you’ll be risking a substantial amount of your portfolio into that option.
Hence, the conclusion is that if you were to buy put options to hedge your portfolio or a specific investment, you should do it before the entire world is submerged in option buying and every second headline on the television speculates where the stock market is heading, because then premiums will be at their absolute PEAK making your so-called “insurance options” quite useless.
Options Selling / Writing
You should know that investors have the option of SELLING call options too. This is commonly referred to as Call Option WRITING. In this case you would sell the contract and collect the premium (as opposed to BUYING the contract and PAYING the premium).
The option buyer would have the option of buying your shares before the expiry date, and you would be OBLIGATED to sell your shares to them. If the stock never reaches the strike price, the contract expires worthless to the option holder (although you will have kept the premium no matter what – and still own the stock in the case of a “covered” call write).
Buying Put Options?
Discover Canada’s best online brokers below and avoid overpaying on a derivative which is expensive to begin with.
Covered Call WRITING
(as opposed to buying) has one particularly interesting use:
It is an alternative way to set a “limit sell order”.
Instead of instructing your broker to sell when your stock gets to a certain point, you can just WRITE or SELL a call option and pick up some additional revenue (the price you get for the contract) to boot. When the stock reaches the strike price, the option holder will exercise their right to buy the shares and you will be forced to sell – again: great if you were instead planning on setting a limit sell order.
For example if you bought a stock for $50 and thought that when/if it reaches $60 would be a good time to sell, you might instruct your broker (or trading program) to automatically sell at $60. In that case you will have made a gain of 20% ($10 gain on $50 investment – ignoring commissions).
On the other hand, if you bought the stock for $50 and instead WROTE a call option with a strike price of $60 and sold that contract for $2.50 – then assuming the stock appreciated to $60, the option holder would exercise their option to buy at $60, and you would be forced to sell. You will have collected a $10 gain from the stock and the $2.50 premium from selling the option contract for a total gain of 25% as opposed to 20%. An extra 5% gain, with the only added risk being that you could miss out on a big-gaining stock (which you would have anyway if you had a sell order in place).
In fact, the gain could be higher if the call option expires before reaching the stock price. If that were the case, you would keep writing the call options on an ongoing basis and keep pocketing the premiums along the way. If the second call option you wrote was exercised then your gain would be 30% ($10 gain from the stock + [ 2 x $2.50 per contract ] ).
Many investors will just keep writing covered calls and collecting the premiums over and over again. When a contract expires, they will turn around and write another one. If you have used this strategy on BCE for the last 5 years (before the run-up) you would have collected not only the healthy dividend from BCE’s stock, but also the ongoing premiums for countless expired call option contracts that you wrote time after time (since the stock was essentially flat for 5 years).
This is called “COVERED Call Writing”. “Covered” means that you own the stock. If you did not own the stock it would be called “Naked Call Writing”. Naked Call Writing can be a VASTLY RISKIER proposition because if the stock’s price increases dramatically you will be forced to sell shares at the strike price (by short selling – like in The Big Short) and then covering your short at a higher stock price.
Let’s look at an example of Naked Call Writing:
You do not own ABC which is trading at $50, but you decide to write a naked call option contract with a strike price of $54 and an option premium of $2, expiring in 4 months. If ABC doesn’t get to $54 within 4 months, you will have pocketed the $2.
BUT, let’s say that ABC shoots up one day to $60. In this case, if the option holder exercises their option of buying ABC at $54, then you must provide ABC to them at $54/share. In order to deliver the shares, you will need to buy ABC on the open market at $60/share. Therefore, you bought at $60, and sold for $54 for a $6 loss. You still pocket the $2 for selling the option contract in the first place, so that reduces your loss from $6 to $4.
You can see from this example that if the stock moves significantly, your losses can be extreme!
The world of options is an interesting one. And there are MANY other option strategies that we have not mentioned – some for engaging large amounts of leverage and enhancing returns, and some for mitigating risk by hedging your portfolio or through other means. All in all – options present many interesting opportunities for investors of all risk levels – so if you had always thought that “options are too risky for me” – you may want to learn more about them.
Writing Covered Calls?
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Best Online Brokers for Buying Options
We have covered online brokers in Canada extensively on MDJ, and our conclusion is that Questrade is the #1 choice for Canadians for all ETF and stock trading. When it comes to options, Questrade is definitely usable and friendly (view my own experience with it below), but it is by far not the cheapest with $1/contract fee. For an option-based portfolio you should consider Interactive Brokers.
Sign up promotion with Questrade:
How to Write a Covered Call Option in Practice with Questrade
As the last couple option trades that I made were with Questrade, I’ll step through the process with their interface. Although this description may be specific to Questrade, it should be very similar to other interfaces (at least it is with CIBC and iTrade).
Pick a Security to Option
Let’s assume that you have an equity that you are willing to write a call option against. Ideally, it’s an equity that you’d sell at the strike price anyways and not fret if it gets called away. For example, in this case let’s assume that you own at least 100 shares of Suncor (SU), and it’s getting close to the price you’d like to sell it anyways. As one option contract equals 100 shares, you’d be able to write one covered call on Suncor.
Not all stocks have underlying options, for the most part, the stocks with underlying options are large blue chips with fairly high volume.
To start, you’ll want to go to the “options” portion of your interface. With Questrader Web, it’s the “Trading Centre” tab -> “Options”. From there, you’ll see this form on the right side:
If you’ve made any trades before, the form above shouldn’t be too intimidating. Here’s an article on how to read traditional stock quotes which includes bid/ask explanations.
Symbol: The symbol is straight forward, which is simply the stock symbol for the underlying stock that you want to trade options with.
In this example, I used Suncor which is traded on the TSX. From there, click the magnifying glass to get the options quote and options symbol which brings up the table below. Simply click the “trade” link for the option that you want to trade and it will automatically populate the order entry field. Read further down for details on how to decipher this table.
Reading the table: Options expire every third Friday of the month, which is the contract date above. In this example, I chose the June expiry which displays corresponding quotes for each option available. Referring to the table, everything above the $38.57 shaded line is “in the money” while everything below is “out of the money”. The more “in the money” the trade, the higher the premium that option seller will receive. The further the strike price is “out of the money”, the lower the premium but the less likely the option will be called away.
If I choose a $40 strike price, this means I’m willing to sell my Suncor stocks for $40 providing that the option buyer pays me a premium of $90 (ask price x 100) per option contract. If Suncor closes higher than $40 on June 18th, it is likely that my position will get “exercised” thus called away. At that point, it’ll be the same as if I sold 100 shares for $40 plus whatever I collected as a premium. However, if the stock closes lower than the strike price, then the option will simply expire and I get to keep my shares (and the premium!). At that point, I’ll likely rinse, repeat and continue collecting premiums.
#Contracts: One contract equals 100 shares of the underlying stock. So if you own 200 shares of Suncor, but you only want to write an option against 100 shares, then put 1 in this field.
Limit Price/Order Type: I personally always use limit orders to prevent surprises when buying or selling. You can see from the table above what the bid/ask prices are for each option. Note that the bid is what the buyer is willing to pay, while the ask is what the seller is willing to sell for. Both prices will likely fluctuate so it’s best to set your price close to the going rate and let it happen. Stops are typically used to automatically sell a position should it fall to a pre-determined price.
Transaction: This is where some investors can get confused. For call option writing, the option to choose is “Sell to Open“. This simply means that you are selling the option to open the position. If you want to buy back the option that you sold, or buy any option “long”, you choose “buy to close”.
Duration: This is the duration that the order will remain open if not executed immediately. Day will keep the order open until the end of the trading day and Good Till Canceled (GTC) will remain open until manually canceled.
Preferred ECN: Most of the bank brokerages do not allow ECN to be chosen. Even if they do, I always leave it on auto. Brokerages like Interactive Brokers will charge extra if the Auto/Smart ECN routing isn’t selected.
AON: This stands for All or None, which means if you can’t trade the number of shares/contracts that you indicate, the trade will not execute.
This concludes the very basics of selling/writing call options with an online stock broker. If you have any questions, or anything to add, please leave them in the comments.
The Equity Collar – Another Risk Reduction Options Strategy
Speculation and Hedging are the two main reasons for using derivatives. Speculation is the taking on of risk, and hedging is the reduction of risk. Within both broad categories, there are varying degrees of each. The Equity Collar is very much a hedging strategy designed to reduce risk.
Perhaps as a means to facilitate understanding I will start with an investor profile and then work in the strategy as a solution to her problem. Let’s say that Sally is 64 years old and has accumulated a sizeable portfolio that is strictly invested in an ETF that tracks the entire stock market (collars work with individual stocks too though). Let’s say that this stock market is trading at 10,000 right now and the ETF’s unit value is $100. The markets have pulled back recently, and Sally is unsure if we have hit bottom or if there is more downside to the markets.
She would like to retire at the end of this year (9 months from now) at which point she has decided she will then switch her portfolio to 50% equities and 50% fixed income. She owns 5000 units of the ETF for a total portfolio value of $500,000.
She feels strongly that with the recent pull-back in the markets that if we are at a bottom, the market will have a positive year and end up at maybe 10,800 points, or up 8%. At the same time, she realizes that in the short term the markets can pull back further and doesn’t want to erode her retirement savings any further if that were to happen as she is 9 months away from retirement as mentioned.
If she wanted to protect her portfolio (or insure it from further losses) she could buy a put option on the ETF with a strike price of $100. This put option gives Sally the right (but not the obligation) to sell her ETF shares at the strike price of $100/unit up until the option contract expires. This now protects her from losses in her portfolio up until the expiry date of the option (which in her case would be 9 months from now).
So for example, at the end of the year if the market had dropped from 10,000 down to 9,200 (a loss of 8%), her ETF units will have similarly dropped from $100/unit to $92/unit. However, Sally could exercise her right to sell her units for $100/unit. Therefore she protected her portfolio from loss.
Of course, as with any insurance there is a cost involved which I have omitted up to this point. Let’s assume that the cost of the put options are $2/share to purchase. In this case, to completely protect her portfolio she would need to buy 50 put option contracts (an option contract is for 100 shares) to insure her entire $500,000 portfolio. This would cost her $10,000 in total ($2/share x 5000 shares). Once you factor in this cost, then really the portfolio is insured to not fall below $490,000 because you would have to pay this $10,000 cost no matter what happened.
For some people, this cost of insurance might be too high and they may want to find a way to reduce or eliminate it. If Sally were to turn around and SELL a call option (this means she is giving someone ELSE the right, but not the obligation, to buy her units) for a strike price of $110, she might get $1.50/share from the sale of that contract. This is what is known as writing a covered call.
In this case, if she wrote (sold) 50 call option contracts with a strike price of $110/unit, she would receive $7,500 in premiums ($1.50/share x 5000 shares). This could be used to offset the purchase of the put options of $10,000 for a net cost to Sally of $2,500 versus $10,000.
The trade-off is that she is now guaranteed no more than a 10% gain on her portfolio as the call option holder would exercise their right to buy Sally’s shares once they reached over $110/unit.
What is the end result? Sally is guaranteed to have between $497,500 and $547,500 by the time she retires. She has protected her portfolio from a loss of no more than 0.50%, but has limited herself to a maximum possible gain of 9.5%.
It is possible to completely offset the bought put options’ premiums with the sold call options’ premiums if Sally were to lower the strike price on the call options she sells to perhaps $108. In this case she might command a higher premium of $2/share for selling the call options which would completely offset the cost of the put options. In this case her portfolio would be bound between $500,000 and $540,000 (guaranteed return between 0% and 8%). Again though, Sally is trading off even more upside potential for her portfolio.
The simultaneous purchase of a put option with the sale of a covered call option is known as the Equity Collar.
I mentioned that an Equity Collar can be implemented with individual stocks and in fact it can be implemented with any optionable security. For a perfect hedge, you would match the options to the underlying security. However, if you have a portfolio of 20 Canadian blue chip stocks, this is a lot of work for a perfect hedge.
An imperfect hedge would use an option on a proxy of your portfolio – which in the case of a portfolio of 20 Canadian blue chip stocks would be options on the TSX/60 index. This would have a high enough degree of correlation to your portfolio that you could accomplish the same results, give or take 50-100 basis points perhaps, with only having to worry about 1 set of puts and calls.
Bottom Line on Options Trading
Options pose an opportunity for significant leverage in your portfolio. It enables the “sophisticated investors” to hedge potential losses or, alas, to increase the level of speculation risk (compared to stocks and ETFs). Selling options and particularly covered options is a solid way of collecting premiums at a reasonable risk (as long as they are COVERED). In the right hands, options are a powerful tool. Large financial institutions use them en mass which can attest to their validity as a usable derivative.
With that being said, options are likely not for you. There are easier and safer ways to let your money work for you. Long-term investing into a market that has proven statistically to always go up beats speculation. Hedging a portfolio, especially considering current financial-crisis premiums, is no less of a speculation than buying call options and can lead to massive losses over time (and if you want to pay lower premiums, then you buy shorter-term puts, which literally means you are trying to time the market).
Written for MDJ by a variety of writers including FT and Preet Banerjee – Canadian financial author and fintech entrepreneur.
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