Options are commonly associated with high-risk investment strategies. In this post, we briefly explain simple option strategies and how they can reduce risk and add value to your portfolio.
What is an option?
Before we can dive into specific option strategies, we need to understand the mechanics of options. In a nutshell, an option is a standardized agreement between a buyer (or holder), and a seller (or writer), to exchange a security (underlying) at a future date (expiration) for an agreed-upon price (strike).
The buyer of an option buys a right: either the right to purchase (call) or the right to sell (put) the underlying security. For this right, the buyer pays a premium. The seller of the option receives the premium and in turn has an obligation to sell, or to buy the security.
Options exist for most listed stocks, ETFs, and major indexes. For the US, listed options trade at the Chicago Board Options Exchange (CBOE). Thanks to this, the availability of options, in conjunction with ample liquidity, should be guaranteed at any time.
The market determines the premium of an option through supply and demand. However, much research has been done on options pricing, most importantly, the Black-Scholes model. In essence, these models explain that in a risk-neutral world, we can determine a fair market value for options. At this fair market value, the option premium is in equilibrium with the expected discounted return of that option.
There are two components to option prices:
- The intrinsic value is the amount, by which the option is in the money. Therefore, the intrinsic value is always greater than or equal to zero. On expiration day, the intrinsic value becomes the amount the holder of the option receives, and the writer of the option owes.
- The extrinsic or time value is the remainder after we subtracted the intrinsic value. This value reflects the probability of reaching or exceeding the strike price by expiration. The time value decays and becomes zero on the expiration day.
Options on stocks and ETFs are physically settled, meaning that the underlying changes hands, when the option is executed. Index options cannot be settled physically, and are therefore settled in cash instead: the option holder receives the amount by which the option is in the money from the option writer.
At any point in time, there are puts and calls available, with a multitude of expiry dates, and strike prices. Together, they form the options chain.
On April 26, the S&P 500 closed at 2,939.88. Here are some call contracts, expiring on May 17, 2019, from the options chain:
- The right to buy S&P 500 on 05/17 for 2,915 costs $43.30. As the S&P 500 is currently trading much higher than 2,915, this option is in the money.
- The obligation to sell S&P 500 on 05/17 for 2,945 points is compensated with $23.20. As the S&P is trading close to this strike, the option is at the money.
- The right to purchase S&P 500 on 05/17 for 2,965 points costs $14.20. As the S&P is trading below this strike, we consider the option out of the money.
Here are some put contracts, also expiring May 17, 2019:
Put options are identical to call options, but with directions reversed. Here is one more example:
- The right to sell S&P 500 on 05/17 for 2,870 points costs $10.90. As the S&P is trading above the strike, this option is out of the money.
The protective put strategy aims to protect us from excessive losses, should the value of a security we own decline. Typically, we buy a protective put out of the money by the maximum amount we are willing to risk. The protective put strategy acts as an insurance policy. Also, just like insurance, we pay a premium to receive the benefits.
Should the underlying decline below our strike price, our option will increase in value accordingly, making up for the difference.
This strategy has the following characteristics:
- pay debit on day of entry
- unlimited profit potential, through the ownership of the security
- limited losses, through holding the option
The following graph further illustrates the profit and loss of buying a protective put with a strike of 2,870. On the horizontal axis, we have possible prices for the S&P 500 on our expiration day of May 17. On the vertical axis, we see the profit and loss:
If until expiration on 05/17 the S&P 500…
- … falls to 2,870 or even below, we will lose a maximum of $80.78. This amount is the sum of the amount by which our option was out of the money, and the premium we paid for the contract.
- … continues to trade around 2,940, we will have lost the premium we paid for our option, which is $10.90.
- … climbs by 10.90 points, we will break even.
- … rises by 50 points, we will participate in this rally with $39.10. This amount is the difference between the S&P gains and the premium we paid.
As we can see from these examples, protective puts limit the downside of an investment. In this sense, they are similar to stop-loss orders.
The covered call strategy aims to create additional income from a security we own. Typically, we sell covered calls out of the money by an amount we deem ‘enough’ of a maximum profit. We sell a part of our profit expectation and receive a premium. This premium offsets the cost of our underlying position.
Should the underlying stay below the strike price, the call will expire worthlessly, and we get to keep the premium. Should the underlying increase in price, we will benefit from that increase up to the strike, but any increase further than the strike goes to the option holder.
In summary, this strategy has the following characteristics:
- receive credit on the day of entry
- limited profit potential, through our obligation to sell
- unlimited loss potential, through the ownership of the security
The following graph further illustrates the profit and loss of selling a covered call with a strike of 2,965:
If by May 17 the S&P 500…
- … falls by 100 points to 2,840, we will lose $86.08. This amount is the difference between the decline in the S&P and the premium we received.
- … trades around 2,926, we will break even. We calculate this by subtracting the premium received from the current price.
- … lingers around 2,940, we will make a profit of $13.80, which is the premium we received.
- … rallies to 2,965 or above, we will participate in this with $38.92. This amount is the sum of the amount by which our call was out of the money, and the premium received.
These examples show, how with covered calls we trade a possible future upside, for a guaranteed immediate payment.
Combining long puts with short calls creates a collar. With this strategy, we limit our loss potential through the long puts. At the same time, we reduce the cost of the puts by also selling calls, which in consequence limits our maximum profit potential.
In summary, this strategy has the following characteristics:
- typically pays a small debit on the day of entry, as the premium received for the calls offset the cost of the puts
- limited profit potential, through the short calls
- limited loss potential, through the long puts
The following chart shows the profit and loss of a collar with a put strike at 2,870 and a call strike at 2,965:
- As with the protective put, we are insured against the S&P dropping below 2,870
- As with the covered call, we reach our maximum profit when the S&P climbs to 2,965 or above
- Because the credit received for the call exceeds the debit paid for the put, we make a profit of $2.90, if the S&P keeps trading around 2,940
We can use collars to gradually reduce the risk and return of a long position we hold, up to the point of almost neutralizing this position.
As with any other investment, profits from option trades are taxable. There are two essential categories:
- Options on exchange-traded stocks or funds receive the long-term or short-term capital gains treatment, just like the underlying would.
- Profits from listed options on broad indexes, like NASDAQ 100 or S&P 500, are treated 60% long term, and 40% short-term capital gains.
We very much hope that this post provided some insight into option strategies. At Bertram Solutions, we pride ourselves in doing independent research, and this post is a good example of our approach to analyzing investments.