Investing in Options: rewards may outweigh risks
To an Investor, Options may seem overwhelming at first; but it's easy to understand their net benefits, if one appreciates a few key points and seeks advice.
In these days of low returns, uncertainty, turbulence and volatility; an Options strategy probably has a place in any Investor’s portfolio. As an Options Investor, one can literally be: “paid to wait”.
If Options strategies are properly constructed and managed they can significantly enhance an Investor’s portfolio through added income, protection, and even leverage. Poorly used they carry significant risks. One should seek professional investment advice to determine if the risk-weighted, cost-benefits are appropriate for one’s investment objectives and portfolio.
1.Options are a special investment tool
As an Investor, one’s objective is 2-fold across a spectrum of financial assets.
· To make money – a return on your capital invested.
· To do so with the minimum acceptable level of risk.
Investor portfolios are usually constructed with several asset classes. In general terms, the investment universe includes: stocks/equities; bonds; ETFs; funds; indexes; commodities and other exchange traded asset classes. Options are another exchange traded investment asset class.
Options are a form of derivatives. Their value is derived from some other underlying investment asset with regard to its future price. For a stock option, its value is derived from the future price of an underlying equity stock.
When used correctly, Options can provide returns beyond those of equity-, bond-, fund- and commodity-only portfolios.
2.Options trading is not equity trading – it has more flexibility
Options derive their power from the fact that the Investor does NOT necessarily own the underlying equity: one is merely the trading in the direction of the future share price, with an obligation to Buy/Sell.
At the simplest level there are two types of Options; giving the Investor the ability to buy/sell an underlying equity stock at a fixed price before a fixed date in the future.
· CALL [buy] option is the right, but not the obligation, to buy a stock
· PUT [sell] option is the right, but not the obligation, to sell a stock
That fixed price is called the "exercise price" or "strike price". The fixed date is the "expiry date". The cost of buying an option is called the "premium": the base source of additional gain beyond the intrinsic value of the underlying equity. To be “Out of the Money” means one’s Call is above or Put is below the strike price. To be “In the Money” the obverse applies: Call below/Put above the strike price.
Now for an example
An Investor has £5,000 to invest in the stock market and has chosen Amazon (AMZN) which is trading at £165. S/he has a choice;
i Directly invest in shares
At a price of £165 per share, 30 shares can be purchased for £4,950. Over the next two months the share price increases by 10% to £181.50. Setting aside all fees and costs, if the 30 shares are sold then the Investor realised.
a cash return of £5,445 on 30 shares;
a net return of £495 (5,445-5,000), or;
10% on capital invested. Not bad!
ii Use of Options.
At the same time a call-option on the AMZN stock, with a strike price of $165, expiring in two months from investment date costs £5.50 per call lot or $550 per contract (100 lots). The Investor can buy 9 options for a cost of £4,950. As the option contract controls 100 shares, the Investor is effectively making an investment on 900 shares.
If the stock price increases 10% to £181.50 at expiration, the option will expire “in the money” and be worth £16.50 per share (181.50-165 strike), or
£14,850 on 900 shares;
a net return of £9,990, or;
200% on the invested capital. Better!
This simple scenario demonstrates how a much larger return may be realised from investing in Options compared to investing in the underlying asset directly. Much better in fact; as time, volatility and leverage have been risk managed sensibly.
Investing in Puts would be the exact reverse. In both cases a premium would need to be considered: either as an additional return or cost.
Options trading is not stock trading. For the educated Options Investor, that is a good thing because option strategies can be designed to profit from a wide variety of stock market outcomes to manage future uncertainties that affect price (time and volatility being two of several dimension). These Options strategies can be accomplished with limited risk.
Many seasoned and sensible Investors would use a pairing strategy: a combination of straight equity investment and then Call and Put options to hedge the initial underlying investment position. Recent live IAG trade is a case in point.
3.The prospect of abnormal gains must be seen against risks entailed
One of the major difficulties for Options Investors arises from not understanding how to use Options to accomplish their financial goals; because Options trade differently than stocks.
As an Investor, the choice of equity is a function of choosing an appropriate company, determining the basis of its stock value and timing of entry/exit. being able to pick the correct. If you can measure risk (maximum gain or loss for a given position/period) then one can minimise it. Thus use of Options as a hedging mechanism.
Statistics reveal that on average: 10% of Options are exercised; 60% traded and; 30% expire worthless. This reflects the hedging/insurance use of Options.
Experience shows that many individual Options day-traders fail to exercise caution in the search for rapid, and outsized returns. As the example set out, the seeming prospect of ‘easy money’ can lead the ill-disciplined and ill-advised Investor astray. These individuals tend to pursue high leverage trades and buy Deep Out Of the Money (“DOOM”s) Options. Especially true when choosing more speculative forms of derivates, such as a “naked” Options strategy or even ‘spread-betting’ with its allure of tax-free gains. Statistics show that 80% of spread-betters lose. The inherent leveraging effect of such ‘bets’ can be disastrous.
Thus a “covered call writing” approach, allows the Investor to realise the benefits of Options investing by smoothing out the future prospects, as offered by the Written Fund or trackers offered by the CBOE. Also, an equity-led and structured options approach offers a hedging approach, as cited above.
4.Options are powerful because they can enhance an individual’s portfolio
The intelligent use of ‘Options’ allows one to make the most of equities, bonds and other asserts on one’s portfolio that are traded on exchanges.
There are a number of reasons one can make rewarding enhancements by investing in Options.
·Low-cost strategy: Investing in Options with a well-structured strategy gives one the opportunity to enter and exit positions quicker and with less risk than other securities, such as stocks and mutual funds. It’s also significantly cheaper to purchase an option than to buy the underlying asset (ie the shares of the stock). So, one can control the same number of shares with far less capital.
Diversity: Because Options are so much cheaper than buying the actual stock, you can benefit from an increased number of investment opportunities. One’s capital will go further, increasing one’s profit potential.
Greater net benefits: When the stock moves you can benefit even more with an option. Let’s say a stock moves from £10 to £20. That would bring you a 100% gain in shares. However, a call option move from £1 per contract to a £5 contract would bring a 500% gain. Therefore, one can profit more and in less time with an option; IF the assumptions and the related Options contracts are suitably structured.
Options can succeed where other sectors fail: Whilst some sectors of the market fail, Options can succeed. This is partly because you do not need to exercise your option to profit from it. Plus, volatility itself can be profitable.
Effective hedge: Options are useful against a declining stock market to limit downside losses.
Generate recurring income: This is achieved through the use of premiums.
Smoothing out overall returns: A possibility if one employs a ‘covered call writing’ approach on an underlying holding of equities. This Options strategy is especially appropriate in all but strong Bull markets.
Mutually beneficial: Although Options are often built on stocks; combining the benefits of both, they can bring greater benefits. Primarily, but not exclusively, because one can sell an option to create income on the stocks one already owns.
At its simplest it is entirely possible to construct an Options strategy that allows one to be “paid to wait” at minimal risk.
In summary
While not for every Investor, Options investing should be considered as a sensible enhancement to any investment portfolio. Consult a financial specialist, such as Gate Capital, for a tailored suggestion.