Retail Investor .org

SO YOU THINK YOU UNDERSTAND OPTIONS !


This page will not teach you options trading. It attempts to focus investors on the basic issues that must be clarified BEFORE they do any trading. Although this website tries to encourage investors with a "yes you can" attitude, in the case of stock options there is a big chance that you probably don't know what you don't know. Test yourself. Read this paper on the myths of Covered Calls. It uses a conceptual approach with no Greeks or math so you should understand it. It is a good guess that 99% of readers won't. But if you cannot argue the author's points yourself, you have no business playing in the options market.

The lingo is commonly used as a test by brokerages to evaluate the retail investor's knowledge of options. They won't let you trade unless you can define what is meant by arcane terms used only in the industry... "write", "premium", etc. The reality is that you can trade effectively without knowing the lingo. Most trading software you will use to place orders uses normal words like "buy" and "sell". And conversely, knowing the lingo does not mean you understand what you are doing.

Graphs and more graphs are a staple of every introductory options course given by the local adult night-school or brokerage promotion. What is never made clear is that the graphs

  • represent the point of view of the option buyer, very rarely the seller's POV.
  • calculate the expected profits at only the end of the option, not the values along the way.
  • don't include the all-important transaction costs, that have a far larger impact on options than on stock transactions.

The courses available to the public are

  • given mostly by people who use the lingo to impress you, even while it inhibits your learning.
  • fail to appreciate that one half the reasons people trade derivatives is to REDUCE risk (Options Are Risky ... FALSE).
  • never address how the investor can himself put a value on the option. How he can decide which (if any) of the chain is the best to trade.
  • don't address your objectives or motivations for the trade. And their appropriate strategies.
  • don't address the probable emotional response to stock moves, and your, probably wrong, response. Or the alternate choices.
  • leave you with the impression that no follow-up actions are required.
  • don't address how changing implied volatility and time premium can wipe out all your planned gains.

Can You Hedge A Stock's Downside With Options? Will buying a put option on a stock you own allow you to participate in its upside while protecting you from the downside? In other words you can you get the best of both worlds - all the upside but none of the downside? Common sense tells you it cannot be done. You must pay a price to get rid of downside risk.

You own the stock because you think it will be increasing in value. Why fritter away that upside by paying premiums to protect a downside that you don't think is probable? If/when you decide the stock has more probability of declining you should sell it. Your cash should be deployed where you DO think it will have a positive return.

By the time you get worried enough to consider buying insurance (a put option) most everyone in the market will feel the same. The price of options changes with market sentiment. When people fear losses the price goes up. At that point the cost of the insurance will exceed your expected downside from the stock. After all, if you thought the probability of a price fall was high you would be shorting the stock, not holding a long position.

The counter-argument usually made here is to concede "yes, the option's premium will have increased, so instead of buying a put you should sell a call". Since the premium received reduces your cost for the stock, so your downside risk has also been reduced by that same amount.

But it hasn't. The risk remains. Risk refers to the unknown. There is no way to know if the option premium's value will cover actual stock losses. Remember, you DO believe the stock's rise is the most probable. That is why you own it, instead of shorting it. Selling calls is selling that upside. So this strategy also works AGAINST the probabilities you think are most likely.

There is a possibility that the markets are not perfectly priced, and you may hedge the downside by selling the stock and buying a call instead. This technique is explained in this FinPipe article.

              

TRADING OBJECTIVES


The strategy you use, your emotional response to results, and the appropriate follow-up strategies all depend on what your objectives are. These may be either of

  1. The Total Return objective looks at the combination of the stock and option in total. Investors have no emotional attachment to the stock. They aim for balance of downside protection and upside potential.
  2. The Incremental Return objective is to augment the return investors realize from their equity position. Downside protection is of less importance because of your confidence in your own brilliant stock picking, or because of a safe portfolio base of T-bills.
  3. Leverage can be the objective when in-the-money calls are bought at essentially intrinsic value. The time value is considered interest on the unpaid liability. See the discussion on leverage.
  4. Hedge Debt or Equity positions that may be high yielding because they are risky. Part of the yield can be spent on options of the underlying stock, which will react more strongly to bad news. When indexes are used it is not the portfolio's $ value that is hedged. It is the volatility, measured by Delta and Beta.
  5. Currency hedging is accomplished when the leverage used (above) is in a foreign currency. The resulting short position in that currency will offset the long position inherent in owning the stock. See the discussion on hedging
  6. Arbitrage profits can be gained by insiders who can trade without transaction costs - not retail investors.
              

DETERMINING THE VALUE OF OPTIONS TO YOU - EXCEL SPREADSHEET


When presented with the complete list of options on a stock (the chain), with different strikes and different maturities, how can you decide which is best for you? Are any appropriate? Especially in Canada, there is a wide spread between the bid and ask price and little trading volume. You most likely have to accept the price offered by the market maker.

Some of the profit and loss projections under different assumptions can be automated in an Excel spreadsheet. Here is a spreadsheet that generates some criteria for ranking calls. Since the concepts measured by the columns are not usually included in courses, spend some time looking at the calculation to fully understand what is being measured. The trade-off between the different criteria is a purely subjective decision.

Options are all about risk and risk is a mathematical concept. This spreadsheet is just a start. Professional options traders have access to many more automated metrics and computer models. Although the message of this website is "yes, you can", in the case of options it is more like "well maybe you shouldn't".

              

REFERENCES

The text book considered the Bible of options is "Options as a Strategic Investment" by Lawrence G. McMillan.
The source for market data on Canadian Options is the Montreal Exchange.
The source for market data on US Options is 888Options.
The Cdn income tax treatment of gains and losses from holding options - created by Cesnick and published in the Globe.
More Cdn tax treatments from the Montreal Exchange.
A discussion of the Canadian tax treatment of options from TaxTips.ca
An article on how to manage a portfolio of options.