I have to admit – 2020 has been a year like no other and has forced many people to re-evaluate their investing strategy. For the Frugalist Investor, that has meant crossing the Rubicon into options trading as a way of capitalising off of market volatility.
Options trading has traditionally been viewed as a sort of specialist profession, followed mainly by banks and fintech companies. I hold up my hands to say that in the past I took this a step further: it appears to be dangerous and downright risky if you don’t know what you’re doing.
In this five-part series we explore options, what they are, how they work, and give you practical examples of good trades you can do and learn from today.
First Principles
Warren Buffett perhaps summarises it best when he talks about the most common pricing model for options prices, the Black-Scholes method:
“We made one — as I mentioned last year — we made one large commitment that basically was — had somebody on the other side of it using Black-Scholes and using market prices — took the other side of it and we made $120 million last year. And we love the idea of other people using mechanistic formulas to price things, because they may be right 99 times out of 100 but we don’t have to play those 99 times. We just play the one time when we have a differing view.”
What he is driving at is the fact that the vast majority of the time there may not be any good trades in the options market. In fact, the options market itself is somewhat flawed because it is based on mechanistic pricing models about volatility (in the past). That doesn’t say as much about the future as we’d like.
To profit from these discrepancies you need to be patient and to understand the investments that you are trying to drive first. It may be every 1 in 100 times there’s a fantastic trade to be had.
Here is a visualisation of the stock market and option markets from a helicopter view:
The size of the entire world stock market, across the planet, encompassing everything from Apple to Zillow Group is estimated to be $89.5 trillion. Sounds big right?
The size of the entire world’s derivative and options market is…. Well, let me put it to you this way, the graphic cannot fit on this website. It’s estimated to have a notional value of $1 quadrillion dollars ($1000 trillion). So before you quit your job and start day-trading options, take a seat with a pot of coffee and be prepared to learn. Loads.
Here’s what you can take as first principles on options (for the beginner’s out there):
- Options trading can have a range of outcomes, from reducing risk to extremely high levels of uncertainty and risk
- Rather than viewing it as “getting in and trading” you should be prepared to not do much trading, until you see a high value opportunity. And probably let a fellow trader who is coaching you find that first high value opportunity so you can learn from it
- Try to avoid trading too often or taking on too much risk
We’re going to do a very high-level overview and hone in on one strategy that – if used effectively – could allow you to purchase stocks for 15-20% cheaper than they are today.
Join a Trading Group
I joined a very successful trading group and have upskilled myself on basic options trading quickly. I strongly recommend that beginners consider doing this: go to Seeking Alpha and find a premium service which is accessible here. Join a trading group and learn from real people doing actual options trading.
If opening a trading account with a broker sounds cumbersome, and you don’t fancy signing up for another service just to learn, I would recommend seriously considering whether you want to trade options in the first place!
For me it made more sense to get stuck in with a small amount of money and the support of a trading group. You can learn quickly and it is less theoretical than attending an options course, many of which are expensive and don’t necessarily have the chance to convey the concepts well in a real-life setting.
Understand Market Conditions
The S&P 500, Dow Jones and Nasdaq indexes all sold off sharply as we went into the Labour Day weekend in 2020.
That means two things: 1. Stocks are falling on aggregate, and 2. Volatility has risen. You can see that here:
Nasdaq composite has fallen 6.2% within a matter of days
The volatility or VIX index has risen 33.9% within 5 days
The rise in volatility may not look like much when compared to what happened in March 2020. However, new investors who are starting with options should understand that the measure for options isn’t “price,” so much, like it is with stocks.
It’s volatility. So what happens when volatility rises 33.9% within 5 days?
Options contracts get more expensive! Many rose by 34% or more, some are 50% more expensive than they were last week.
Use the Right Strategy at the Right Time – or Else…
Generally speaking, this is a huge area, but let’s establish a few facts first in order to help an investor position where they should be depending on the market conditions.
Have a look at a brief chart:
Before you even learn the terminology and learn how to execute the trades, the purpose here, is to educate you on the fact that you need to do four things well to succeed at options trading:
- Understand and identify the correct market conditions (harder than it sounds!)
- Follow measures like volatility and gauge whether they are going up or down
- Understand and apply the right trading strategy, on the right type of security
- Do all of this at the right time!
Options Trading – Basics
So a stock is an instrument that allows you to take part-ownership in a company, right?
Well, an option is a contract – this contract allows an investor to buy or sell an underlying security or instrument at a predetermined price over a predetermined period of time.
Let’s take Apple. The stock is worth $108.22 today and if you bought 100 shares of stock (part ownership in the company) you effectively own 1/171 millionth of Apple!
With Options you have four basic ways of “betting” on the likely price of Apple’s stock in the future, which is currently $108.22.
Here are the four basic options trades:
- “Buy” a Call – You have the right to own the security in the future at an agreed price
- “Sell” a Call – You receive a premium in exchange for the right to buy the stock at an agreed upon price in the future.
- “Buy” a Put – You have the right to sell the stock at a certain price in the future
- “Sell” or “Write” a Put – You agree to own the underlying security in the future at a more favourable price
If you are extremely BULLISH on Apple and think it is going to the moon, you would either Buy a Call or Sell/Write a Put.
If you are extremely BEARISH on Apple and think it is going to the dumpster, you would either Sell/Write a Call and Buy a Put.
This may seem complicated – well, because it is! Many investors, even those with years of experience, fail to appreciate the subtlety and difficulty inherent in this system.
Practice: Covered Calls
Thankfully you don’t have to learn it all at once. You can practice with the tried-and-tested approach: “Sell” a Call, in particular, something called a “Covered Call”.
A Covered Call is used when you own the underlying stock. Let’s say you own 100 shares in Apple and it is worth $10,822 USD today. You might think you’re being clever by sort of trying to time the market and buying and selling Apple shares. Oh, my dear friend, but there is another way!
Instead you can keep your 100 shares of Apple. Say you think Apple is going to trade flat or sideways, or even go down over the next few weeks. Rather than selling why not “Sell” a Covered Call option?
The option grants somebody else the right to buy your security a predetermined future price over a set time duration.
Here is why you might want to do that:
Apple is down about 19.4% from the peak it reached on September 1st. I don’t see it racing back up. Instead of selling the stock I will use my 100 shares to “write” or “print” an option on the option market that grants somebody the right to buy Apple in October 2020 for a set price.
Looking at Yahoo’s options tables for Apple I see the following:
If you look at the highlighted box you can see several things. For October 30th (next month) at a “Strike” price of 120.00 I would be entitled to receive a premium of $2.59 if I were to SELL a Call Option on my 100 shares of Apple. (If you were really bearish you could sell a $109 call option for a $6.53 premium!)
If I “Sell” this Covered Call, I agree to give somebody else my shares of Apple if they hit $120 by 30th October (in 1 month’s time). But I receive $2.59 per share – and 1 option contract controls 100 shares – so I receive $259 in cash as a premium.
Here are the 3 outcomes:
- If Apple falls significantly and it is sitting at $95 in October, then I get to keep the $259 cash premium. That works out to a 2.39% return on my Apple shares in 1 month (28.7% a year!)
- If Apple rises above the strike price of my option ($120 set above), then my shares get “called away” to the option holder. They are sold at $120 and $12,000 is put into my account less the commission. I made $259 in options premiums and the stock got sold for $12,000 = total profit $12,259, which represents a 13.27% profit from where I started ($10,822 value of shares I have today). I can buy the stock back and sell a covered call again!
- If Apple hits exactly $120, you get to keep the stock. The option expires worthless and you pocket the $259 premium and earn yourself a profit.
In essence – for all three scenarios I make money, and it isn’t until the stock price rises above $122.59 (Strike at $120 plus premium at $2.59) that I start to lose money
Conclusions
Absolutely do – not – run, before you can walk!
Take your time and discover a bit of a passion for investing. The only way to get competent with options is to have a working knowledge of stock trading. If you don’t understand the basics of stock trading, then go back and practice in that hemisphere first before applying what you know to the more advanced concepts
That being said the “Covered Call” strategy outlined above is a great way for Frugal Investors to earn extra income without taking on excessive risk.
Happy trading!
