Trading in options is far from the beaten path of your typical investor, especially selling them. Some investors do use this strategy though, but they can be plenty tricky.
The world of options trading is a complex one to say the least, about as far as you can get from your normal buy and hold investor. Those invested in Apple stock for instance usually will hang on to the stock in both good and bad times, perhaps parting with it when the bad times get too bad, or they need the money.
If someone is willing to go as far as to trade options, options in any form are more daring then doing anything with stock positions. This is especially the case when you are looking to sell options, otherwise known as writing them, where you’re taking the obligation to deliver the shares to the option buyer should it finish in the money.
Steven Sears, chief investment officer at StratiFi Technologies, who make investment advisory software, has recently spoke on the advantages of writing put options on Apple stock, as opposed to just buying the stock outright and speculating on price increases.
Typical investors won’t readily understand why anyone would do this, but the upshot of this play is to make money when a stock isn’t moving up particularly well but the risk to the downside isn’t too high either. If a stock stays in a tight range, and ends up right where it started when the put was sold, you get to collect the premium and have that to show for your effort.
The premiums for the lower-risk put writing that Sears is recommending ends up being on the paltry side though, with his current recommendation yielding just 40 cents per contract. That’s what people are willing to pay for it right now, for a level that is well beyond arms reach and provides a good buffer should things go wrong.
When We Get Paid to Take on Risk, We Need to Manage it Properly
Sears is certainly about managing risk, and this is what his company does for advisors, providing software analysis of the risk profiles of clients to help them manage it better. Risk management is sorely neglected with most investors, and you’re going to be stepping into the forest of options trading, which can be extremely risky if not managed well, you really do need to make sure that you are not looking to bite off more than you can chew.
He is clear on the need for maintaining the ability to buy the stock if needed, where enough cash would need to be set aside in one’s account for this purpose. Most investors who do this sort of thing use what is called writing a covered put, where they would already own and maintain the needed shares to cover the put if needed, and given that they would normally plan on hanging on to them anyway, if the put gets exercised, this means that the stock has turned bearish enough that it may be a good idea to exit at this point anyway.
As long as the distance to the strike price isn’t so big that you would have sold your stock before this, this strategy can be a good hands-off approach to using options, where you either collect the premium or unload your shares in a scenario where you would have anyway, or at least should. We really should be putting a cap on our risk, and whatever that cap may be, you can sell put options into it.
There is also an escape key to this if you indeed plan on exiting before the put, although it is best to set this level to where the exit is desired. You can always get out of an options position though, and if you are only part of the way down to the strike price and you want to get out, you can.
Keeping cash in reserve instead spares you from losing money if the price of the stock declines but not enough to force you to cover or exit. If your strike price is 20% below the market and it declines 10%, and you own it, you have collected the premium but have suffered the 10% loss with your stock position.
If you don’t own it and are just keeping the money that it would take to get in the stock on the side, you spare yourself from these potential losses, and provided that you hold it, you will only lose money on the play if the option hits. You also miss out on any gains the stock makes though, so this is a strategy that is best suited for stocks that we expect will trade in a fairly tight range.
Minimizing Risk Here Means Getting Paid a Lot Less to Take it On
A fairly tight range and Apple don’t really go together that well. Although Sears’ suggested level to sell our puts at right now is 25% away, and that might sound like a lot, Apple was below $150 as recently as January 3 of this year, and it giving back this much or more is not out of the question.
That actually is a lot of room though, and we actually may wonder whether Apple giving back even half of this amount would not be enough to have its further movement pretty suspect, meaning that the likelihood of it going down further from whatever may have caused this may be undesirable.
Tightening this up will require more monitoring and more potential decision making, and this is not at all aimed at traders, but people who generally prefer things as simple as possible and even a one and done approach like this appears to be. You sell the put, you watch, you win or lose is the idea here, not unlike trading binary options but our instead tying our own hands behind our back rather than the trade not allowing for an exit until expiry.
This does come with a price though, and part of this is only getting paid small amounts to sell the put versus higher ones that we would receive if we did not set our strike price so low. Even setting it 50% lower than the market will involve some likelihood of happening if left unmanaged, and we do see 25% down moves over a life of an options contract even more often.
However, setting it at 25% does give us a lot of wiggle room, and we need to realize that while some people will hang on to the bitter end, even to the point of riding the option further down when it strikes, we aren’t obligated to do that, and in a lot of cases, bailing on these trades is the wiser choice. If we are prepared to wiggle though, it makes more sense to get paid a little more at least and better take advantage of this flexibility.
Sears does mention the possibility of covering prior to expiration, and this not only serves to limit our risk, it may also provide a real opportunity if the stock has bottomed and its prospects are improving. Getting paid an options premium as it moves down but covering it as it rebounds is a nice situation, provided that it works, where we make money both from the option and by holding the stock through a rally, but we need to be careful with this and make sure that this isn’t just a bump up on the way down.
Continuing to hold the option position or covering it with stock are both undesirable, and we have to seriously question why we would want to buy a declining stock at that point when there are other options available. While at this point this is clearly a trade gone bad, and we can’t just walk away clean from it, we’re already exposed to the downside in both cases and we do have the money to cover it wherever it goes, because we set aside enough at the outset for this.
There is no free lunch here, even though covered options writing is often presented to investors as a nice way to make some extra money. Most options do not finish in the money, which means that the seller wins, but some do, and when they do, we can be stuck with losses many times what we got for selling the option.
In the end, this all works out so that there is no real advantage on either side, where the expected return of both selling and buying options are close to zero. It is not that people who buy options are suckers and we can join forces with the great machine and gain an advantage here. We may indeed have one, we may be able to call a stock better than the market, but more often than not our perceived advantage is not an advantage at all.
There is the risk side to account for as well, meaning that it is not enough for us to break even with these trades net of trading costs, we need a large enough positive expectation to offset the greater damage that losing money involves over winning a similar amount. It does hurt more to lose, and therefore, our wins need to make up for this difference.
This options strategy involves placing ourselves at risk of market crashes if nothing else, and smaller but still quite significant losses when these trades go against us. The amount of compensation we’re getting for taking on this risk is almost meaningless actually, but we potentially could lose a lot of money here if we’re not careful.
If we do want to take a shot at this, we need to be attentive enough to price fluctuations, and when in doubt, we need to get out of the trade, not by covering it by buying stock but by closing out the option position. We still may wonder whether this is a good move overall, perhaps not even one worthy of the time spent on this, and especially with tying up all those funds by needing to hold them in cash, but it still can be managed, and would need to be.