Never buy stock again! Fortunes can be made in the securities market, but there is a better way than buying stock for the long haul. And that better way is the use of stock options, a little employed technique that is known by few, except as a speculative technique akin to gambling. The purpose of this article is to discuss some of the techniques that make the buying of stock an error.
Buying Calls, a Lower Cost Option
When stock is purchased, the investor puts up 100% of the purchase price, or 50% in a margin account and pays interest on the debit or loan balance. And an investor should only buy stock if the security is expected to rise immediately and dramatically. If the stock rises 15%, from 50 to 57 ½ for example, there is a 15% return on the cash investment, or 30% on the margin investment. The alternative is to purchase a call option. Typically, a 3 month call with a strike close to the market will cost about 7% of the stock price. If the stock rises 15%, the call investor makes more than 100% return on the investment. Granted, the absolute dollar return is less, but the return on investment (ROI) is much greater. The conservative rule of thumb is that if the investor has the money to buy 100 shares of stock, he should at the most buy only one or two calls, keeping the remainder of the funds in a safe haven like a money market fund.
Avoid Stop-Loss Risks
When stock is purchased, it is purchased because it is expected to rise immediately and dramatically. If wrong, the position should be exited. This is usually done through the use of a stop-loss order, where a sell order is placed below the entry price, possibly 10-15% lower. All too often the stock drops to the stop-loss point, the position is liquidated at a loss, and the stock rises to new heights. The investor was stopped out, so misses the future rise. After several similar occurrences, most investors become disenchanted with stop-loss orders having been whipped-sawed, and so quit using them. Instead they migrate to the use of mental stops to sell if and when the stock declines. But with mental stop points there is a risk. After a small decline, hope springs eternal, and the investor does not sell being convinced it will soon rise. Then the stock drops further, and the investor soon has such a large paper loss that he can not emotionally afford to take the loss. “After all, it is only a paper loss.”
Buying a call option rather than the stock solves the dilemma of the stop-loss. The call option costs less than the loss if the stop was executed, and protects against losses for the entire life of the call option, no matter how many times the stock’s price drops, or how far it declines. The loss can never be greater than the premium paid, the 7% in the assumption, and if the stock ultimately rises significantly during the option’s life, the investor profits. Thus the investor has the benefit of the upside appreciation, with a tight cap on the potential loss.
Buy Stock in the Future at a Lower Price
An investor can go out and buy stock today, at the current market price. Investing the 100% of its cost in a cash account, or 50% in a margin account. Then if the price rises he profits, if it declines, he losses.
Consider a better way. He sells a put option with a strike below the current market price. Assuming the market price of the stock is 53, so the investor sells a 3 month put with a strike price of 50, for a premium of $300. By selling a put, the investor is guaranteeing to buy the stock at $50 should the buyer of the put decide to sell it to him. To sell one put, the investor places with his broker a good faith deposit of 20% of the value of 100 shares of stock ($5,300) less the points out of the money (50 strike price is 3 points below the current market price of 53), and less the premium or $300. Thus the investor deposits $460 ($1,060 minus $300, minus $300). These funds can earn interest in the account and the put seller has received $300. If the stock never declines below 50, the put seller pockets the $300 as a return on his $460 invested, which represents a healthy ROI. If the stock declines, he buys the stock at 50, which is less than the price existing at the time he would have originally purchased it, and having earned the $300 premium, the actual cost of the stock is 50 less 3 or 47 a share. Furthermore, all of his capital has earned interest for the entire time period. And the put seller wanted to have a long-term portfolio position in the stock anyway.
Generating Additional Income on a Portfolio Position
Having acquired stock through put selling at a future point in time and at a very advantageous price, income can be generated by selling covered calls against the newly acquired stock. This involves selling a call on each 100 shares of stock owned. The strike price would generally be above the current market and a premium would be received. For example, 100 shares is put at 50, creating a portfolio position at $50 a share less the premium received from selling the put. The investor now sells a 3 month call at 60 for $200. No additional funds are required to be deposited with the broker other than the purchase cost of the stock. The only requirement is that the stock be retained in the account. By selling a call the investor has obligated himself to sell the stock at 60 should it rise that high. If it does, great! He pockets the $200, plus $1,000 on the stock position. If it fails to rise above 60, he still pockets the $200, and sells another call option for additional premium. No matter what the stock does in the market, the call sell has earned the $200 premium. He also receives any dividends paid on the stock.
Neutral on the Stock
Let’s assume you like the stock. You sold a put, and because the stock declined, you were put 100 shares. Your cost is $50 per share less the premium or $3 for a net cost of $47. You still like the stock, but don’t love it. You would be willing to buy more at a still lower price or sell the shares should it have a near term run up. An appropriate strategy would be to sell a straddle. A straddle is a combination of a put and call. One call is sold above the market (55) for $300, and a put is sold below the market (45) for $300. In this case, the investor is willing to exit the position at $55 or purchase another 100 shares at 45. And while both sides could theoretically be executed, it is a rarity. And if it does happen, who cares. But normally, either nothing happens, with the stock trading in the range between the higher call strike and the lower put strike, or just one side is executed. But regardless of the outcome, the investor has earned two premiums ($600). Thus if the stock is called away, the net selling price is $55 plus $6, or $61 a share, and if put the new cost is $45 less $6, or $39 a share.
Words of Caution
Options can be tricky, and even dangerous for any investor that overextends. The following are several important rules to avoid that risk.
- When buying call options only buy 1 or 2 calls for each 100 shares you would have purchased otherwise.
- When selling puts, only sell 1 put for each 100 shares you would normally have purchased.
- Only buy calls on stocks that you expect will have major price advances, or are very volatile with wide swings anticipated to be greater than the premium paid.
- When selling puts, you must like the stock, and thus be willing to own it. This approach works best on stocks with strong upside potential.
- Do your research. The option strategies mentioned here work best with stocks that are fundamentally strong, that have an upward price bias, and stocks that you are comfortable having in your portfolio for long periods of time.
There are many option strategies available. These are but a few that are simple to employ, have high possibility of profit, limited risk, and significant benefits over buying and owning stock. A carefully crafted option purchase and selling strategy has made direct stock ownership less desirable.
Dr Kermit Zieg can be contacted at the Florida Institute of Technology