Options sellers have good odds of a trade working out in their favour. Boon Tiong Tan explains how it’s done
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Last issue, we talked about high-dividend stocks and why they’re not as safe a bet as many investors assume. What is an alternative way to achieve a similar return? The answer is to sell options. Options are more complicated than dividends but it is not rocket science. Anyone who has a grasp of basic mathematics can learn to trade options.
Let’s start with an example. Say Apple’s share price is US$140. You think it is too high and you are happy to buy 20% lower at US$110. You can sell a put option with an exercise price of US$110 with one year expiry to earn a premium of US$5.5. This is the income you earn for setting aside US$110 to buy the Apple stock in case it drops below US$110 in one year’s time. The return on the cash you set aside is US$5.5/ US$110 = 5%. Doesn’t that sound like a good deal? You earn a 5% annual return on your cash and get a chance to buy Apple shares at a 20% discount.
No matter what happens to Apple’s price a year later, this US$5.5 is in your pocket. If Apple’s stock price is above US$110 then, you can sell another option (either Apple or another company) to earn more income from your US$110 cash. You can keep repeating this and keep earning the premiums if your options are not exercised. If Apple’s price is below US$110 in a year’s time, you are obliged to buy it at US$110.
WHAT IS A STOCK OPTION?
It is a legal contract giving the buyer the right to trade a stock at a contractual price (known as an exercise price) within a timeframe. A buyer of an option pays a premium and the seller earns the premium. The value of a premium is derived from a stock. The premium of an Apple option is derived from Apple.
The value of a premium is determined by many factors. The three most important are volatility, exercise price (or strike price) and expiry date. The more volatile the stock, the higher the premium. Gamestop’s premium is multiple times that of Apple because it is a much more volatile stock. The nearer the exercise price to the stock price, the higher the premium. Lastly, the further away the expiry date, the higher the premium. An option that expires in three months has a higher premium than one that expires in one month.
There are two types of options: call and put. Call options give buyers the right to buy a stock at an exercise price. Put options give buyers the right to sell a stock at an exercise price. A buyer of a call option believes the stock price is going up and a buyer of a put option believes the stock price is going down. Their options are profitable if the prices move far enough in the direction they anticipate.
It’s true that options prices are, by nature, much more volatile than the underlying stocks; it’s not uncommon for a stock price to move a few percent and the option price to move a few hundred percent. An option is like a Lamborghini with a top speed of 350 km/h – it can be very dangerous if you drive it recklessly. However, you can choose to drive it slowly and safely. One way to do that is to follow the Apple example given at the beginning of this article – sell a put option only if you have enough money to buy the stock.
What you are doing here is similar to an insurance company selling an insurance product. The company collects the premium now and pays the claim later if need be. You ‘pay the claim’ by buying the stock if the stock price drops below your exercise price at expiry.
What is the risk? As a put option seller, you are obliged to buy Apple at US$110 at expiry no matter how low the stock price goes, even to zero. While this may sound scary, it is the same risk as investing in a stock. Selling a put option with enough cash to buy the stock is no riskier than owning a stock. The advantage of selling a put option over owning a stock is you earn a premium and have a chance to buy a stock at a lower price.
PLAYING THE MARKET
Exchange Traded Funds (ETFs) have options too. All big ETFs like SPY (S&P 500 ETF) and QQQ (Nasdaq 100 ETF) have very active option markets. If you sell a one-year-expiry QQQ put option at a 20% lower exercise price, your annual return is 4.3%. For SPY, it is 3.7%. You get to earn about 4% while waiting for the major US indexes to drop 20%.
You can also sell a put option on a high-yield stock. Ping An Insurance has a 4.6% dividend yield. A 20% lower exercise price earns you a 9% return. Not only is the return higher than the dividend yield, selling the put option is also safer. You don’t have the risk of owning Ping An – until you own it at 20% lower. If you want to buy a stock with high volatility, the return is juicier. Take Zoom, the current price is US$260. If you sell a put option at a 20% lower exercise price of US$210, your annual return is 11%. If the exercise price is 30% lower, the annual return is still a good 6.8%.
If you believe cinemas will come back strongly and are happy to buy AMC, your annual return for a 20% lower exercise price is an amazing 40%. Even if you only want to buy at 60% lower than the current price, you can still pick up a 20% return. For stocks like Gamestop and Kodak during their most volatile days, you could earn a decent return of above 5% for an exercise price 90% lower than the current price.
A few warnings about the options market. Don’t be tempted to become an options buyer. Most options expire worthless, which means most buyers lose money. The occasional wins aren’t enough to pay for the frequent losses. Don’t treat options as lottery tickets. Something else you need to know: You can potentially lose the premium hundreds of times if you sell a call option without owning the stock. Never do that.
OPTIONS VERSUS HIGH-DIVIDEND STOCKS
So, should you buy high-dividend stocks or sell put options? One advantage of selling put options is that the premium you earn is certain and upfront. Dividends are never a sure thing and you have to wait a year to collect. Another advantage of options is you can choose a precise risk/ reward. If you are a risk taker, you can choose a 10% lower exercise price to enjoy a higher return. If you are more cautious, you can choose a 30% lower exercise price for a lower return. Selling options will suit you if you are not comfortable with your stocks’ price swings. You only have stock risk when the stock price falls below the exercise price.
Options require you to choose and trade at least once a year. If you choose a shorter than one-year expiry, you have to work even harder. High-dividend stocks have the advantage of requiring less work. You spend some time choosing and buying one, then you simply sit back and collect your dividends. However, such good high-dividends are rare and hard to find.
Selling put options has some advantages over selling high-dividend stocks. But which is better comes down to your personality. One key to the success of investing is to find the right product and market that suits your character. Still can’t make up your mind? Do them all and have the best of both worlds!
Tags: finance, Financial advice, shares, stocks
DB resident Boon Tiong Tan (CFA) has worked as a trader with banks like HSBC and Morgan Stanley for over 20 years, and he is the author of A Stock Investment Book For The 99%. For information about the one-on-one courses (money management, stock investment, options trading and chess) that he provides for both adults and kids, email [email protected]