I was talking with some of my more options-oriented friends last night about using options as part of the value investor's toolbox. But before anyone runs out to start selling puts on stocks in which they may have an interest, here are some key points that my friends made that are worth reviewing.
Using options can give me a huge advantage over investors who do not -- provided I stay true to the principles of deep value and time. I usually use options to create a long position in an undervalued stock at a more favorable price. Should the stock not fall to the price where I am forced to buy shares, I keep the premiums and add to my cash hoard.
Before you begin, keep in mind that options are complex instruments with complex pricing elements and trade much differently than shares of stock. You need to do some basic research and understand the options markets before you start trading. Using an options calculator to price options will not give us an edge in the marketplace. There are far more accurate models for option valuations built by folks who design working rocket ships as a hobby. Using the basic pricing theory keeps us form giving away too much of an edge to those rocket scientists and the supercomputer we are trading against. Our edge comes from stock selection and valuation.
Never make the mistake of just reaching for fat premiums. Selling puts is very seductive. When prices are rising, it seems like easy money. I did a study once that showed that selling options on the market indices at prices 5% below the previous month's close on a month-to-month basis was profitable about 85% of all months. That sounds like the closest thing to a free lunch. It would be, except the losses in the few losing months exceeded the gains of the profitable ones by a substantial margin.
The trap for options sellers is collecting a few premiums on the right stocks and then getting enticed by the fat premiums on high-flyers like Apple (AAPL) or Chipotle (CMG). You may collect some fat cash for a few months, but if there is bad news out of the company or the market corrects, you can lose an extraordinary amount of money very quickly -- and end up owning a stock you have no interest in holding long term. The trick to using options to enhance profits as a value investor is to start with stock valuation, not options value.
In addition, you should never post exchange or brokerage minimum margins. When you are selling puts, post the entire potential cost of the trade in cash. If you are selling $6 puts on Radio Shack (RSH), your brokerage firm will probably let you get away with putting up just a few thousand dollars for 10 contracts. Don't do that. Post the full $6,000 needed to pay for the shares. There is a tendency to think that I have $20,000 in my account to buy Radio Shack, so if I just use the exchange margin, I can sell 100 contracts and not just 30.
I know that sounds silly, but I was a broker for 25 years and have seen the seductive allure of what looks like free cash lead some very smart individuals down the primrose path of minimum margins. If the options sell for $0.50, you can take in $5,000 instead of just $1,500. However, if the stock goes down, you are going to find yourself owing more than 3x the amount of stock you wanted. When I sell a put option, I want the price to fall and be sold to me at the strike price. The premium is a bonus -- it's not the ultimate payoff. Post the full price in cash for every contract you sell.
There are some key differences with options trading you will need to be aware of as well. Often when I see a stock trading right around my calculation of asset or intrinsic value and I want to buy the shares at a discount to the number, I will go ahead and enter a good-until-cancelled (GTC) order 20% below the market price. As long as the fundamentals do not change, I can just let the order sit there until it gets filled. That's not the case with options. The measurements used to calculate the value of the option will change daily with movements in the price and overall market direction and volatility. You need to recalculate the order every day and re-enter it until you get filled. If you leave a GTC order out there, odds are you will once again have the pleasure of paying for market makers lunch that day.
Options can be a very powerful tool for value investors. However, you need to do the homework and learn how options are valued and traded before adding these to your regular investing approach. You will find that it is time well spent and should help add to our fiscal well-being many times over the effort and cost expended.
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