An excerpt from The Compound Code: An Expert Guide to Trading Stocks & Options.
The focus of this chapter is on how to use options to generate income, enhance returns, and provide downside protection. Options can be complex and confusing, if not outright intimidating. Many people think of derivatives in general or options in particular as risky. To be sure, any vehicle can be a source of danger depending on how it is used. A knife in the hands of an ill intended robber is dangerous; a blade in the palm of a talented surgeon can be lifesaving. The purpose of this chapter is to provide you the tools to use options in conjunction with quality dividend-paying companies to your financial advantage.
An option is a derivative, which is simply a fancy term for the fact that the option’s movement in price is a function of an underlying security, be it a stock, ETF, index, or other investment vehicle. The easiest and best way to think about options is to compare them to insurance. When you buy fire insurance, for example, you sign a contract (the policy) and pay money (the insurance premium) in order to be protected against the occurrence of a fire for a specified period of time (the duration of the contract). If the event does occur prior to the expiration of the contract period, then you receive whatever your contract calls for (e.g., the replacement cost of your house).
The insurance company hopes the event you are protecting yourself against never occurs. If your house does not burn down, the insurance company keeps the entire premium you paid without making any payments itself, an outcome that adds to the company’s profits. Of course, accidents do occur, and insurance policies are paid out periodically. The insurance company’s goal is to write (AKA sell) enough policies and price them in such a way that after collecting all the premiums and paying out all the claims—and paying operating costs—it ends up with a big profit. Let’s apply this analogy to options. Say you are planning to buy a house in the next year. You anticipate the house will cost $1,000,000. You intend to borrow 75 percent of the cost, thus you need $250,000 as a down payment. You own 1,000 shares of Company X, which currently trades for $270 per share. For tax or other reasons you do not want to sell your shares today—perhaps you think Company X’s stock will go up in the coming months or maybe you want to wait until your holding period exceeds one year so that you are subject to capital rather than income gains. However, this is your sole source of funds for the down payment on that home and you want to be sure that you have at least $250,000 when it comes time to purchase the house. How do you ensure if not insure this outcome? You can buy stock insurance; in this case you can buy a put option, which gives you the right, but not the obligation, to sell a stock at a given price during a specified period. For those speculating on price appreciation, a call option gives you the right to buy a stock at a given price for a certain time period.
Back to our soon-to-be homeowner. In this case you might buy Company X insurance to be sure you will receive at least $250 per share for your stock during the course of the contract. In other words, you would buy—pay a premium for—a put option that would give you the right, no matter what happens with Company X’s stock price, to sell the stock for a fixed price while the contract is in effect. Were the company to go bankrupt and the stock to fall to zero, you have locked in a preset sales price of $250 per share. In order to buy 1,000 shares’ worth of protection, the put buyer would need to purchase ten contracts, as each option contract represents 100 shares of the underlying security. For an option priced at $3.50 per contract, you would be fully covered by paying $3,500 (10 contracts X 100 shares per contract X $3.50 per share = $3,500 of premium paid). By entering into such a put option contract, a Company X investor is certain to have at least $250,000 of stock when it comes time to make the down payment. Whether this insurance is worth it, whether the contract is of good value, is up to the buyer of the insurance.
As with stock, options have a bid price and an ask price, the former being the price at which an option can be sold and the latter the price at which the option can be bought. The difference, or delta, between the bid and ask is the spread. You will often also see the last trade listed on a quote screen. This is simply the price at which the most recent trade was made. This may differ substantially from bid/ask quotes for relatively illiquid options. (For portfolio valuation purposes, you should use a mid-point between bid/ask rather than the last trade price). A typical option might be trading at $0.80 by $0.90, meaning that you could sell the option for $0.80 per contract and buy the option for $0.90 per contract. Often you will see such wide spreads in options—sometimes 30 percent or more—whereas highly liquid securities might trade at a .01 percent spread. In options trading in general, and particularly in cases where liquidity is low, it is vital that orders be placed on a limit order rather than a market order basis. If you are not filled at your initial limit price, the spread will often narrow, at which point you can adjust your limit order to see if you will get filled there. Aswath most things in life, you won’t get anything unless you ask! When stocks traded in fractions, options premiums traded in one-eighths. The introduction of decimal pricing helped to narrow spreads in options, which are inherently less efficient in terms of bid/ ask spreads than equities due in part to their lower liquidity.
Scott Kyle and Patrick Fischer are authors of The Compound Code: An Expert Guide to Trading Stocks & Options.