How to Protect and Enhance Your Investment Portfolio
1. Options 101 “ How to Protect and Enhance Your Investment Portfolio with Options” Barrington Capital Management, Inc . A Registered Investment Advisor Bob Lawson (952) 835 1000 THE OPTIONS INDUSTRY COUNCIL C O I
3. The Options Industry Council 2 Options Strategies or Stock Investors For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy. Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options . Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606 or call 1-888-OPTIONS or visit www.888options.com. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Supporting documentation will be supplied upon written request.
19. Intrinsic Value And Time Value 16 Stock Price = $56.00 Price of 50 strike Call = $8.00 Time Value = Total Premium – Intrinsic Value For a 60 Call at $2.10 What is the intrinsic value? What is the time value? Stock Price = $56.00 Strike Price = $50.00 Time Value = $2.00 Intrinsic Value = $6.00 Total Option Premium (or Price) = $8.00 $0 $2.10 Intrinsic Value must be greater than or equal to zero. note:
20. Intrinsic Value And Time Value Quiz 17 $78.00 $36.00 $41.00 Option Price Intrinsic Value Time Value Stock Price Option 70 Call 35 Call 42.50 Call $10.50 $3.75 $1.65 $8.00 $2.50 0 $1.65 $1.00 $2.75
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24. The Ins And Outs Quiz 21 $55.00 $33.00 $77.00 Stock Price Option In, At, Out 60 Call 35 Call 75 Call Out In Out
82. Thank you for attending! Visit the OIC Web site at www.888options.com
Notas del editor
(Introduce yourself and OIC. Give schedule for the evening: present until 7:20 p.m., 15 minute break, talk from 7:35 p.m. until 8:45 p.m.) There will be time for questions and answers during the presentation, so feel free to raise your hand and ask what is on your mind. How many of you have experience using options? This is intended to be a basic-level presentation. For those of you with some experience, the first 30 minutes review some basic definitions and concepts. After that, we will get into strategies, and I think that will be of interest to everyone.
Please read the Characteristics and Risks booklet, which is included in your packet. It contains valuable information.
There are many reasons for buying stocks, some long-term and some short-term. The opportunity is unlimited, but the risk is big. There is also a hidden cost to owning stocks, and that is the interest that is foregone. The question is: Is there a way to change the risk/reward of owning stocks? The answer, of course, is “Yes!” And that is what we are going to talk about tonight.
Without options, you only have three choices: buy stock, sell stock short, and stay out of the market. How many of you have ever sold stock short? (Make appropriate comments: I see we have quite a bit of experience, or only about 10% of you, and that is typical.) We are going to talk mostly about investment-oriented strategies tonight, but we will touch on some short-side strategies.
This slide shows you why every investor and trader should want to learn about options. The concept is that options give every investor and trader more alternatives. How many of you have seen these diagrams? Well, having seen them, and truly understanding them are two different things, and my goal tonight is to get you to understand at least one or two of these strategies. And one more comment. You may never use some of these strategies, and that is okay. But the options market makes possible these and many more strategies that investors who only buy stocks cannot take advantage of.
I’m always asked, “Which is the best strategy?” Well, let me tell you right up front that there is no “best strategy.” Options do give you more choices, but you have to understand how the different strategies work, for what forecast each is best suited, and what the risks and potential rewards are. The concept is that option strategies offer different trade-offs, different positives and negatives than stock-only strategies. Since option volume has been growing over the last 30+ years that listed options have been available, it seems to me that more and more people are finding them useful.
As I said, this first section may seem a little basic for those of you with experience, but we will get into some strategies shortly.
Options are contracts. They do not represent ownership in an underlying company, like a share of stock. For an equity option, the underlying is 100 shares of stock. The question is: Why would an investor buy a right to do something? Why wouldn’t the investor just do that something? Well, that is what we are going to talk about when we get to the strategy discussions.
In my experience, there are several confusing words in the options business and I hope this explanation helps. The words holder, buyer and long all mean the same thing. The buyer of an option has a right to do something. On the other side are the words writer, seller and short. And these words all mean the same thing. The writer of an option has the obligation to fulfill the other side of whatever the option owner has the right to do. Since the call buyer has the right to buy the underlying stock, a call seller is obligated to sell stock. And, since a put buyer has the right to sell stock, a put writer is obligated to buy that stock. For those of you who are new to this, it may sound a little complicated, but the examples we go over shortly will make it all very clear.
As I said before, the underlying instrument of an equity option is 100 shares of the stated stock. In this example, an XYZ 45 Call options, the underlying instrument is 100 shares of XYZ stock. Does anyone know when the underlying might be different than 100 shares? That’s right, when there are stock splits such as a 3-for-2 split (also spin-offs, mergers and acquisitions, and other contract adjustments). In that case, it might be that 150 shares is the underlying for a particular option.
The number “45” in this example is the strike price, and $45 per share is the price at which the call buyer has the right to buy the underlying 100 shares of XYZ stock. It is also the price at which the seller of the call is obligated to sell those 100 shares.
And don’t forget about the expiration date. One big difference between options and stocks is that they do not live forever. Does anyone know when, exactly, a December option expires? That’s right, the third Friday of the stated expiration month. Actually, for technical reasons, options expire on the Saturday following the third Friday, but the last time that anyone can exercise an option is on that third Friday, and that is why it is commonly referred to as “Expiration Friday.”
And of course options are not free. The buyer has to pay for them and the seller gets the money. But look at the stated price of $5.50. Does anyone know how much in real money this option would cost? That’s right, $550. How did you get that amount? That’s right, 100 shares times the stated price of $5.50. For those of you who are new to this, don’t forget options are quoted on a per-share basis just like stocks, the actual price is 100 times that amount, plus commissions or transaction fees.
Two more words that frequently cause confusion to beginners are exercise and assignment. Let’s talk about exercise first. The owner of an option can exercise the right contained in an option by calling their broker and saying “I want to buy the stock, exercise my call” or “I want to sell the stock, exercise my put.” Has anyone here ever exercised an option? Good, I see that some of you have. Well in the strategy examples, we will talk about why a person might choose to exercise and why they might not.
Now the word assigned, or assignment. When an option owner exercises an option, then some option writer must be assigned. Does anyone know how this works? If you three are call buyers, and you three are call writers, and if you exercise while you two hold, then which one of these three is assigned? That’s right, it is random. Each one of the option writers has an equal chance of being assigned. How many here have done covered writing? And how many of you have been assigned early? Were you happy or unhappy about that? When we talk about covered writing after the break, then we can discuss how you might have expected the possibility of being assigned early and what you might have done.
Now I want to give you two more definitions and then I will give you a quiz, so listen carefully. An option’s price has two parts, intrinsic value and time value. In this example, the stock price is $56, and the 50-strike Call has a price of $8. $6 of that total price is “real value” or intrinsic value, and $2 of that total price is “in excess of intrinsic value” or time value. Intrinsic value is also sometimes described as “the in-the-money amount.” How many of you have heard this term?
Okay, now for the quiz. (For each line state the stock price, the strike price of the call and the option price. Then ask, how much is intrinsic value and how much is time value?)
In-the-money, at-the-money and out-of-the-money are the last set of terms I want to introduce before getting into the strategy examples I promised you. (Explain in-the-money.)
(Explain out-of-the-money.)
(Explain at-the-money.) Also, when a stock price is closer to one strike than others, even though it is not “exactly at” that strike, then it is common practice to refer that strike option as the at-the-money option.
Let’s have another quiz.
Before we get into strategies, let’s talk about “exit alternatives.” Options trade all day, every day during trading hours, just like stocks, so if you enter an option position, you have a number of choices. For option buyers, there are three choices. First, in the case of equity options, you can exercise an option at any time prior to the expiration date. This is not typically done, but it is possible. Second, if an option is out-of-the-money, and if your hope for a stock price move beyond the strike price has not materialized, then you can let the option expire. Alternatively, if the option has not yet expired, and if your forecast has changed, then you can simply sell the option. Let’s talk percentages for a minute. Who has an opinion of how many options expire worthless? Is it 10%, 50%, 80%? Actually, The Options Clearing Corporation keeps statistics, and only about 30% of options expire worthless. About 10-15% are exercised, and the rest, 50-60% are closed prior to expiration. So, please, don’t sell options just because you think there is a 90% chance you will make money. We will talk more about this later tonight.
If you write an option, which means you have a short position, then you also have three choices. If it is in-the-money as expiration approaches, then you can wait for it to be assigned. Assignment, remember, is not “choice” like exercise is. If you receive an assignment notice, then you are obligated to fulfill the obligation. If you are short a call and you receive an assignment notice, then you must deliver the stock. Or, if you are short a put and you receive an assignment notice, then you must buy the stock. Alternatively, if the option you are short is out-of-the-money, then you can wait for expiration and let it expire, or you can buy it back. Buying back an option that you are short closes out the position and the obligation that existed.
Now let’s get into our first strategy. We are going to talk about buying calls, but we are going to talk about two different reasons for buying calls. Depending on what your objectives are, you will manage your capital differently. You will plan differently, and you will make a different choice at or prior to expiration.
Just to review the basics quickly…
First we will discuss how the strategy works, then we will talk about the two different reasons someone might decide to buy a call. In this example, stock XYZ is trading at $60 and we are going to buy a 90-day 60-strike Call at $3 per share. But notice the forecast. Not only are we bullish on the stock, but we want to limit risk. This is a very important point as we will see shortly.
First, I want you to fill in this profit and loss table, then we will complete a profit and loss diagram. (Go through the “builds” on the profit and loss table.) No matter what the outcome, the option cost us $3 per share. What is the option worth if the stock price is $70 at expiration? That’s right, it is worth $10, and that gives us a $7 per-share profit. What is the option worth and how much do we make or lose if the stock price is $65 at expiration?...
Now let’s draw the profit and loss diagram. Using the numbers in the right-most column from the previous slide, place dots along the axis that eventually create a diagram of the strategy. Note that the hyphenated line is a simple long-stock strategy, assuming stock was purchased at $60 per share. The important point is that buying calls and buying stock are different . (Also, stock holders may receive cash dividends and have voting rights -- option holders do not .) Buying stock breaks even at $60 and has big risk. Buying the 60-strike call at $3 per share breaks even at $63, but it has only $3 per share of risk.
Now let’s see how a conservative investor might use a purchased call. First, make sure you understand the assumptions. Philip has enough money to buy 100 shares of XYZ stock, so why doesn’t he buy the stock? Because he is nervous! He wants in, but he doesn’t want $60 of risk. So he buys one call for $300 and deposits the balance of his investment capital in a money market account. So what is Philip’s goal? That’s right, to buy the stock. And what is his risk? That’s right, just the $300 plus commissions that he paid for the call. No matter how much XYZ stock declines, all Philip can lose in this example is $300 plus commissions. Someone who buys the stock has substantially more risk. Let me tell you a story. Some time ago, I had a friend who wanted to buy Philip Morris stock at $22. He did not think the company would go out of business, but he knew it was possible. He was willing to take some risk, but not $22 of risk. So this is what he did. He bought a 5-month 20-strike call for $5 per share, and he deposited $2,000 in a money market account. The week he did this the stock dropped below $20, and it eventually went below $17, but my friend knew that all he could lose was $5 per share, and he was willing to lose that if he was wrong. By the time the five months were up, the stock had recovered to $29, and his call was worth $9. So what did he do? He exercised the call, bought the stock with the money in the money market account, and he still owns the stock today above $45. That is a conservative use of an option. I had another friend who was convinced that Lucent had hit bottom when it dropped to $40 from $75, or whatever the high was. He also bought a call and deposited $4,000 per 100 shares in a money market account. That friend was dead wrong! Lucent is below $10 today, and my friend lost $7 per share that he paid for the call. But he could have lost $30 if he had purchased the stock. That is the way that a conservative investor buys call options. Do you have a stock you would like to buy right now? Are you waiting because you are nervous about the market? How will you feel if the stock suddenly rises, and you are left in cash? You could buy a call now! You would have exposure to the upside in the stock and your risk would be limited.
Let’s review what Philip should do if the stock is above the strike price. He should exercise the call and buy the stock. This assumes that his opinion of the stock has not changed. He can always sell the stock if he changes his mind. If the stock price is below the strike price, then he can either buy the stock at the lower price, or he can forget this stock, let the call expire and look for somewhere else to invest his money.
Now let’s talk about someone completely different from Philip. Peter, in this example, is a speculator. He doesn’t want to own XYZ stock, he just thinks it is going to rise in the near future. Look at how Peter manages his money. If he uses his $6,000 to buy 20 Calls at $3.00 each, then how much is he spending and how much is at risk? That’s right - all of it! But is it this simple? What else should Peter be thinking about when he does this? First, he has to have a price target for XYZ stock, and therefore, an exit point for the calls that he buys. Also, Peter needs to think clearly about time. Since options have an expiration date, it makes a difference whether Peter buys calls with 30-days, 60-days or some other time to expiration. Also, if the target time period passes, and the stock price rise does not happen, then Peter has to be disciplined and sell the calls, even if at a loss. That’s right, part of speculating is taking losses. Hopefully, they are “small” losses. But if you carry a long option all the way to expiration, the risk is the full amount paid. Finally, regardless of time, a disciplined speculator should have a stop-loss point. That is a point at which you admit that your forecast was wrong and you close your position at a loss. This is the way that disciplined speculators have to think They have to plan for both good and bad outcomes.
Let me summarize. There are two reasons for buying calls. A conservative investor uses calls with a view to buying the underlying stock and to limit risk at the same time. And a speculator hopes to make a large percentage profit within the life of the option, but the risk is the full amount paid for the call. So the speculator has to be disciplined and plan for exit points - both a profitable exit point and a stop-loss exit point.
Now let’s talk about puts.
To review, quickly,…
As with calls, for puts there are buyers or holders or longs, and there are writers, or sellers or shorts. The longs have rights, and the shorts have obligations.
When a long put is exercised, then stock is sold. When a person with a short put position is assigned, then that person has to buy the underlying stock at the strike price.
Also, as with calls, put owners have three choices. They can exercise, they can sell, or they can hold to expiration and let the put expire worthless if it is out-of-the-money.
People with short put positions have three possible outcomes. If the put is assigned, then stock must be purchased. At that point, there is no choice. However, prior to expiration, a person with a short put can either buy back the put to close out the obligation or you can wait until expiration and let the put expire.
As with calls, we are going to talk about two different reasons for buying puts.
Just to quickly review…
Here is the example. Again, we will first go through how the strategy works, and then we will discuss the thinking process involved. And, since there are two different reasons for buying puts, there will be two thinking processes.
Here is the profit and loss table. (Go through it step by step. First, mention the initial cost of the strategy. Second, determine the value of the option at a specific outcome. Third, calculate the profit or loss of the outcome. Finally, complete the profit and loss table.)
Like before, let’s complete the profit and loss diagram.
So why buy a put? One reason is that, if you are a speculator with a bearish forecast, then buying a put is a limited risk way of trying to profit from your forecast. Compared to selling stock short, the cost is lower, the risk is lower, but the breakeven point is also below the current stock price. So there is a trade-off. It is not that there is a better choice, its that buying puts and selling stock short are different. For the conservative person, buying puts is less risky.
But I said that there is a second reason for buying puts. As we will see after the break, there is a similarity between options and insurance policies. The second reason for buying puts is to insure a stock holding. When you buy a put as insurance, it is described as a “Protective Put.” The goal is not to profit from a bearish forecast, but to limit the risk of a stock investment. Let me tell you about a friend of mine that had owned Cisco for several years, and he has made a lot of money in that stock. But when the bear market started, he got worried. He still believed in Cisco, but he was scared about losing several year’s of capital gains. So when the stock declined from over $65 to the low $40’s, he bought a 6-month 35-strike put. It cost him $4 per share, so it wasn’t free, but it gave him peace of mind. Well guess what. That insurance policy paid off. When the six months were up, Cisco was near $20. At that time, he had two choices. He could sell the put or he could exercise the put and sell the stock. There is no “right” answer to such a situation, but he chose to exercise the put, sell the stock and pay taxes on his gain. Under different circumstances, you or he might have decided to sell the put.
Let me summarize what we’ve gone through so far. The major idea is that options give you a wider range of choices. You can get into stock positions with limited risk. You can speculate on the upside or downside of the market, and you can protect existing stock holdings. All that is required of you is understanding how options work, how to define your objective up front, and then you must have the discipline to follow through whether you are “right” or “wrong.” After the break, we will talk about strategies involving selling options and we will discuss option price behavior.
Okay, let’s get into another strategy. How many of you have done a covered call? My goal is to show you a new way of thinking about this strategy. I think that too many people sell covered calls for the wrong reasons and without realistic expectations. First, I will define the strategy, then we will fill out a profit and loss table and draw a diagram. Then I will talk about the thinking required.
First, the basics. Covered calls are simply buying stock and selling call options on a share-for-share basis. The short call position, remember, is an obligation to sell the stock at the strike price. How you think about that obligation, as we will see, says a lot about your comfort level with this strategy.
So, why sell covered calls? Conceptually, you have to be “neutral” on the stock. What does “neutral” mean? This is subjective, but you can’t be forecasting that the stock will either rise or fall dramatically. And what is the goal? This is where most people fail to plan. Why are you selling a call? Do you want to sell the stock? Do you expect that the call will expire worthless? That is good thinking, but what if you are wrong? What if the stock declines instead of rises? And, if you do not want to sell the stock, what is your plan if the stock price rises “too much”? When will you buy back the call? These are also considerations that must be thought about in advance.
Here is our example. We are buying XYZ stock at $52 per share and selling a 55-strike Call for $1.75 per share. First we will complete the profit and loss table and diagram, and then we will review the standard methods of calculating returns.
First, complete the stock column. This should be easy! Then, what is the profit or loss if the stock price is below $55 at expiration? That’s right, the call expires worthless, and the $1.75 premium is kept as income. But what is the result if the stock price is above $55? Suppose it is at $60. What is the profit, and what happens. The profit is $4.75, and the call is assigned. That means that the stock is sold. We will address whether that is “good” or “bad” after we draw the profit and loss diagram.
(Draw the diagram. Compare it to a long stock position. Note that “neutral” means between $50.25 and $56.75 in this example.)
You need to decide in advance if you are willing to sell the stock or not. If not, you need to know where you will buy back the call if the stock price rises “too much.” You can’t just sell a call and hope it expires worthless. For beginners, it might be best to take the cash, buy a new stock and sell a covered call on that stock. If you do covered writing this way, then you will, most likely, be willing to sell the stock if it rises above the strike price. To me, covered writing is about making a series of small, short-term profits. Covered writing is not about selling calls and hoping they expire worthless. No one can forecast the market that accurately. You are just likely to spend a lot of time worrying -- whether the stock price rises or falls. If you are willing to sell the stock, then if the price rises, you can rest easy knowing that you are earning a profit.
As we all know, however, not all stocks rise in price, so it is equally important that you have a plan for what you will do if the stock price declines. When will you admit that your stock pick was wrong? At what point will you close the position and take a loss? These are important questions you must answer before you enter any position, including covered writes.
Let me summarize. Covered writing is a strategy for a “neutral market” forecast. And, while the primary goal for most people is income, covered calls also establish a pre-determined selling price for the underlying stock. And the premium also provides a limited amount of downside protection. However, covered writing is not an insurance strategy. Finally, I said that having a plan is important. You should decide whether or not you are willing to sell the stock, and you should know in advance what you will do if the stock price rises or falls “too much.”
Let’s move on to another topic. The way option prices behave is a frequent source of frustration, even to experienced option users. My goal is to clear up some common misconceptions about this topic. Don’t worry, I won’t use any mathematical formulas.
The first question is, what determines option prices? That’s right, option prices are determined by the forces of supply and demand, just like stock prices.
But conceptually, options are insurance policies, so the factors used in analyzing option prices are different than the factors used to analyze stock prices. Puts are like hazard insurance. If a stock “burns down,” then the put pays off, just like a homeowner’s insurance policy pays off if a house burns down. Calls are also insurance policies, but they insure the upside. The risk of having cash is not the risk of loss. Rather, the risk is an opportunity risk. If stocks rise while you have cash, then you miss out on the appreciation. Remember the first call-buying example? When Philip purchased a call and invested the balance of his cash in a money market account, he was using the call to insure that he would participate in the price rise of the stock -- if it occurred as he hoped. If it didn’t, then his cash was safely invested with no risk of loss. That was using a call as insurance!
Consider the factors that insurance companies consider when setting the price of a car insurance policy. Why do these drivers pay different premiums? Because the risk is different. Risk is an important factor, but it is not the only factor.
Now look at options. The factors that the options market considers are directly analogous to the factors that insurance companies use. So why are the prices of these two options different, when everything else seems to be the same? Because the risk, or volatility, is different.
So, to analyze an option’s price, you can use The Options Investigator software. By inputting six factors, you get an estimated option price. (Discuss volatility.)
Remember, computers that calculate “theoretical option values” are only guides. They do not make decisions.
Here is another quiz. Make sure you understand the assumptions. The question is that, if the stock price rises today (theoretically no change in time to expiration), then how much will the at-the-money 50-strike Call change in price? The answer is that the call rises approximately 50 cents to $3.50. The stock price rose by $1, but the at-the-money call rose by approximately only half that amount. Why?
The concept is “delta.” (Explain delta.)
Delta varies depending whether an option is in-, at-, or out-of-the-money.
Here is another quiz. How does time affect option prices? Again, make sure you understand the assumptions. In this example, only time changes. It decreases from 60 days to 30 days. So how much does the option price decrease? Only by one-third (approximately) from $3 to $2. Even though time decreased by 50%, the option price decreased by only one-third. Why?
Time decay is non-linear. (Explain.)
Why is option price behavior important? To use options to achieve your objectives, you need realistic expectations. Understanding delta and time decay help you understand what will happen to the option’s price if your stock forecast is right -- or wrong.
The last topic for tonight is LEAPS, or long-term options.
How many of you have heard about LEAPS? How many of you have traded them? The acronym LEAPS stands for L ong term E quity A ntici P ation S ecurities. But, essentially, they are just long-term options. They expire in January. They have different root ticker symbols, and they are not available on all stocks.
One of the motivations for using LEAPS is the lower rate of time decay per unit of time.
I find this information very interesting. If a three-month option is $3.33, then you might expect a two-year option to be eight times as expensive. But the two-year option is only about three times as expensive. And look at the rate of time decay over the first three months.
But there is always a trade-off. In return for the lower rate of time decay, you give up some leverage. Note that if the stock price rises to $53.25 today, then the 3-month option rises 63%, but the LEAP rises only 21%. 21% is still a nice percentage gain, but it is less than that of the short-term option.
Just to restate the trade-off, you give up leverage, but get longer time. Are LEAPS “better”? No, they are just different. Which do you want? That depends on the confidence you have in your forecast and how much time you think you need.
We are coming to the end of the evening, so let me quickly review what we have talked about. First, options are tools. You can use them to invest conservatively, or you can use them to speculate. Either way, you have to understand how they work, you have to know your own objectives, and you have to plan ahead for both “good” and “bad” outcomes.
To conclude, I would like to ask that you do one thing. If you have never used options before, then please consider trying one of the strategies discussed here tonight. You have just spent three hours, and I hope you have enjoyed it. But to complete the learning process, it is necessary to put it into practice. Just try something small. Maybe one or two contracts. If there is a stock you have been thinking about purchasing, but your concern about risk or the market outlook has held you back, then try buying one call and depositing the rest of your money in a money market account. I hope the stock rises and you can exercise your call. If not, then at least your risk is limited to the price of the call plus commissions. If you are more income oriented, then try the covered write strategy. Start by buying some stock you like and sell a covered call. But have plans for both a price rise and a price decline. If the stock rises, are you willing to sell the stock? If so, then you don’t have to do anything if the stock price rises. If not, then have predetermined price at which you will buy back the call. If the stock price declines, then have a stop-loss point. Before you leave, please fill our the evaluation form found in your book. Thank you again for coming tonight. Good luck with your investing.
