What Are (My) Options?

What Are (My) Options?

While most people know that CEOs at large, public companies make far more money than most mere mortals, the actual ratio of CEO pay to median worker compensation (now published by the SEC) can appear truly staggering.  Many Fortune 500 CEOs make between 100 and 300 times the median at their respective companies.  However, most or all of this money doesn’t come in the form of a fixed salary, as the median-comped employees receive, but in the form of stock options.  This makes their pay rather risky; if the company’s stock drops precipitously, not only will the CEO oftentimes lose their job, but the options can become worthless even if they retain their position.  Conversely, if the CEO leads the company well (or the stock market is just in an expansionary period), these men and women with stock options can become fabulously wealthy.  So, as an investor, how can you use stock options in your own portfolio?

First, we need to understand what these financial derivatives are.  Stock options fit into two broad categories:  the right to buy (call) and the right to sell (put).  They have three primary characteristics:  expiration date, premium, and strike price.  There are also two positions for each, the long position and the short position.  It’s simplest to understand through a brief example.  Let’s say I sell Jane an option on 1 share of Apple stock for a premium of $5, which expires in 6 months.  I get $5 today (short position), and Jane has an option (long position).

A call allows an investor to enjoy unlimited upside with no downside risk, while a put allows an investor to profit from price drops.  To illustrate, Jane’s option is a call with an exercise price of $195 and Apple’s stock is currently $190.  If the price falls, I pocket the $5 and Jane does nothing.  However, if the price rises above $195, Jane will exercise her option.  What this means is that Jane will give me $195, and I will deliver to her 1 share of Apple stock, regardless of what the price is.  If it’s $200, I breakeven.  If it’s $205, I’ve now lost $5.  If it’s $300…you can see how Jane’s upside is unlimited.  She pays $195 regardless of what the market price is.  However, the converse is true for the short position; selling an option exposes the seller to unlimited downside.

Now, we’ll assume that Jane’s option was a put, instead, with an exercise price of $190.  If the price rises, I pocket Jane’s $5 as pure profit.  However, let’s say the new iPhone comes out and isn’t well-received.  Apple’s stock drops to $180, and Jane exercises her put option.  I pay Jane $190 for 1 share of Apple stock, even though the market price is only $180.  With puts, the gross profit and loss are limited to 100% of the exercise price (though we can appreciate this would be either highly desirable or catastrophic).  If Apple ceased to exist (bear with me), I would have to pay Jane $190 for a share worth $0. 

Note that I didn’t mention the expiration date or timing.  This is because there are so called “American options” and “European options”.  European options are actually much simpler.  Jane would only have to make the decision to exercise or not on the actual expiration date, 6 months after I sold her the option.  American options are somewhat more complicated, though less restricted.  They can be exercised at any time between the day it’s sold and the expiration date.

Since we understand the basics of how options operate, let’s discuss some strategies to use them correctly.  First off, we’re going to operate under the assumption that we are risk averse (as investors tend to be).  This means we will not open ourselves to downside risk by selling options to boost profits.  Second, there are many much more complicated strategies you can employ, but we’re only going to discuss some of the simpler (but no less effective) strategies here.

The first strategy is a covered call, and it requires us to sell a call option for each asset we own.  Note, this doesn’t violate my ‘rule’ above, because each sold (or ‘written’) option is paired with a share of stock (the underlying asset).  This is typically employed when the investor believes the asset she holds will vary little in price, so she writes (sells) a call option at about the upper limit of where the asset could trade (in order to find someone bullish on the asset).  The call is “covered” because the investor holds the asset she will sell if the option is exercised, thus eliminating the downside.  However, this also limits the investor’s upside, as profit can only equal the exercise price plus the premium minus what they bought the stock for.

The next strategy is a protective put, which is when an investor holds a stock and buys a put option.  As it sounds, it protects the investor from a large decline in price, but allows unlimited upside potential.  This upside is decreased by the option premium paid, so it’s best employed when the investor wants to protect the gains she’s already earned or prevent a catastrophic loss of capital.  It’s also key that the investor believes the stock will rise long-term.  If not, she might as well sell.

Finally, we come to the collar strategy, which entails holding a stock, buying a put, and writing a call.  The put’s exercise price will be below the current price and the call’s will be above.  This is how an investor “locks in” a certain profit, as they have limited downside and upside.  This is useful for protecting profits that you don’t want to realize immediately or that you can’t monetize yet (i.e. if you are forbidden contractually from selling your shares by an employer or acquirer).

With these explanations and strategies, I encourage you to read more on options trading and study your portfolio to see if you could benefit from any of these.  I do encourage caution, as it’s not simply purchasing or selling options.  A significant amount of analysis must be done to determine what price to buy or sell at and when.  There are also more complex strategies that could be more beneficial for your given situation, some of which will potentially be explored in a future article here at SnoQap!


 

Sources

Brooks, Robert Edwin, and Don M. Chance. An Introduction to Derivatives and Risk Management. 9th ed., South-Western, 2009.

Chance, Don M. Analysis of Derivatives for the CFA Program. Chartered Financial Institute, 2005.

Investopedia. “European vs. American Options and Moneyness.” Investopedia, Investopedia, 21 Dec. 2017, www.investopedia.com/exam-guide/cfa-level-1/derivatives/european-versus-american-options-moneyness.asp.

McGregor, Jena. “As Companies Reveal Gigantic CEO-to-Worker Pay Ratios, Some Worry How Low-Paid Workers Might Take the News.” Chicagotribune.com, Chicago Tribune, 22 Feb. 2018, www.chicagotribune.com/business/ct-biz-executive-ceo-pay-20180222-story.html.

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