Strategist Suggests Some Options Plays for Investors

Options

While many investors see options positions as a risky way to hit a big score, options are also used to protect against risk. They all need to come with warnings on the label.

It is always curious to see people recommending options trading of any sort to individual investors, given how complex options trading is compared to stock investing. These two forms of trading are at opposite ends of the spectrum, with stock investing not requiring any skill at all to profit from, and options trading requiring the most skill.

There is a lot of ground in between buy and hold stock strategies and options trading, where we might want to instead point investors toward spicing up their stock trading strategies in ways that are much simpler than trying to talk them into using options positions alongside their stock holdings. They may take static options recommendations made today and neither understand enough about the rationale behind them nor know much about how to manage them in the face of changing circumstances as they hold them.

This is why we are so reluctant to suggest that investors dabble too much in options, as this is a game where you get rewarded or punished based upon skill, based upon the difference between your skill level and the average skill level in the market, which is considerably higher than neophytes who may see a recommendation and swallow it whole.

We see the ads where online brokers have “introduced” everyday investors to not only options trading but to fairly sophisticated strategies that you can just be introduced and somehow expect this to not only be profitable but enough to get pretty excited about. They are set on their way to cross a busy and complex highway that is more likely to see themselves become roadkill than make it to the other side with a bunch of money in their hands and a big smile on their faces.

Of the two ways to use options, to speculate and to hedge, using them to speculate is considerably more difficult, especially compared to trading stocks. Options speculation takes everything involved with speculating on stocks and adds in both future expectations and the element of time decay, where your level of understanding of markets really has to be on point to benefit, otherwise you can make the right call and see your position move the way you thought but still lose money on the deal.

We’ll use a simple example to illustrate the difference between these two forms of speculation, looking at buying call options on QQQ, the ETF that tracks the Nasdaq 100, versus just buying the ETF.

Let’s say we expect the QQQ to recover from its recent pullback from $248 on June 23 to the $240 it dropped to last Friday, and perhaps go higher. We expect things to look better in a couple of weeks and are considering buying calls with an expiration of July 10.

The simplest approach here would to buy at the money calls, and this also compares to buying the ETF here since the strike price of the option and the ETF price will be the same, the current trading price of the asset.

When buying the ETF, we just buy it off of someone that wants to sell us these shares and get out of their positions, so you have two parties that wish to trade and there’s no extra that this will cost you. You buy it at $240 we’ll say, and everything above that is your profit and anything below that represents you going behind.

The call will cost you $5.48, which means that the value of this option will depend on QQQ moving up a fair bit to just get even, but this isn’t quite as simple as seeing the underlying asset move up this much, as with options, there is also the element of time decay, which makes calculating things considerably more complicated.

For example, let’s say that the QQQ moves down over the first few days of the trade. Two things have driven the value of your option down, the fall in the price of QQQ and the time used up to get you to where you need to be to break even on this. We originally have 12 days to see the thing move this $5.48 and now we only have 9 left, and we have to go even further now to get there over less time. Both of these factors will weigh on the value of the call.

You now not only need to predict the direction of an asset, you need to predict it over a pretty tight time frame, where it not only needs to move but needs to move fast enough. Needless to say, this requires a level of understanding and confidence that is at least on a different level than trading stocks straight up, and while these things can be mastered with enough skill and effort, you won’t get it by reading a bit of info on this given to you by your favorite trading platform.

With options, the market prices in a certain expectation, like this $5.48 with this QQQ call, then sets a timer on it which doesn’t just ring at the end of the period but ticks down throughout the trade, and you have to understand both now much the asset should move and how quickly we may expect it. When we add several other concurrent options positions on an asset,this just serves to make the endeavor even more complex, where the chances of being out of your element goes up even higher.

The upside of options trading if you are buying them, or the downside if you are selling them, is greater because options are a form of leverage. If the QQQ in our example moves up by the cost of your premium and moves up that much again, you have doubled your money, because it cost you $5.48 in this case and it went up another $5.48, which is twice as much as it cost you.

Buying options at the money like this at least makes options more intuitive to investors, although amateurs are usually tempted by shooting for even bigger scores, where for $1.91 you could have bought a $248 call, where it has to get there or you lose all your money, but if it goes higher the amount will provide a bigger percentage return using this $1.91 as your reference point.

People shoot for even more out of the money strike prices than that, where the cost is a lot lower but the payoff on a percentage gain basis is a lot higher, but trading should not be seen as like playing the lottery, and a lot of money is wasted by people on options that remain worthless throughout their entire life and never come close to being anything but worthless.

If anyone thinks that this is like jumping on horses that are running like we can do with stocks, they will be in for a rude disappointment. Successful options trading is much more challenging then people with little experience or understanding realize, and we at least need to give this its proper due.

Options Trading Can Be Fun and Profitable but Only with the Proper Know-How

This is not to look to talk people out of trading options, but just like anything else, we need to be up for a task before we take it on. As long as we understand that this is a whole different world and a considerably more challenging one than trading stocks, and are prepared to learn how to do this properly first instead of just reading about a certain play in an article, we’re at least moving from unconscious incompetence to conscious incompetence, a necessary step to get to where we need to be ultimately, conscious competence.

If we do want to dabble in such things, using options to hedge is at least a simpler matter, although still not so simple. When we hedge, we are not even shooting to make profits from these trades, as that is what is called speculation, and hedging has us rooting for the trade to lose in fact, and don’t want the hedge to be profitable, just like we buy insurance and don’t want to use it, but if needed, it will protect us.

We need to make sure that the hedge is worth it though, that it provides enough benefit with its protection to justify its cost, and that there aren’t better ways to achieve the hedging that we seek. While we should still have a good idea of the pricing and value, that’s a lot more important when speculating and as long as our option hedge does what it is supposed to, to kick in at the level that we want to protect and deliver the profits we wish to offset our losses with, then it has at least achieved its intended purpose.

Options hedges, when properly implemented, are far simpler than options trades that we are using to speculate, because we can just buy the put and forget it, where if it finishes in the money we are covered, and if it doesn’t, what we paid is the insurance premium.

Many investors are concerned about this recovery in stocks at least stalling and perhaps even giving back a good part of what we have gained back lately. The QQQ, the ETF that tracks the Nasdaq 100, is near all-time highs, and what’s been happening with the economy is far from an all-time high, and is at lows not seen since the Great Depression.

While there isn’t that big of a link between the near-term economic outlook and stock prices as most people think, and the two aren’t even necessarily related at all, it is not unreasonable that investors might still worry about this and may wish to protect themselves. The best way by far to do this though is to actually watch things unfold and set a point where you feel uncomfortable enough and then either cut back on your positions or just get out completely, and we even wonder why anyone who realizes that they can just do this would want an opposition hedge such as an options put on QQQ anyway.

Some may not want to sell their stocks for tax reasons though but still may wish to offset some of their risk exposure during more turbulent times such as these, and may even want to consider buying put options to accomplish this. This only works well when you’re up against some big potential moves, like the one in February and March, where we can fall a long way and you can use options to take the sting off of these crashes.

We’ve already been there and done that, and the worry these days is more modest, like giving part of the gains back but not a great amount. We want to make sure that we are getting our money’s worth out of this insurance though, so we do need to at least have a look at its price and what we may gain from this to ensure that it makes sense.

The way a stock trader would handle this is to just define the risk that they want to take and place a stop loss order there. Investors can do the same thing even though hardly any investors take advantage of this, and you can place a good until cancelled stop order that will stay on your account until you take it off, so this stuff isn’t just for traders.

The idea here would be to use not a fixed stop but a trailing one, where for instance if you hold QQQ shares and their value drops by 10% for instance, this would get you out. Stop loss orders are free, where options do cost money, but if you insist on staying in, stop loss orders won’t let you do that but options will.

If we are looking to hedge though, we don’t want to be too cute and actually look to speculate instead unless we really know what we are doing, and investors by definition aren’t professional options traders and need to stay within their limitations. This is especially important when you’re looking to sell options, which means that you collect the premium and take the risk. This is not something that you want to do without the proper knowledge and skill though.

For example, Julian Emanuel of BTIG recommends investors sell QQQ calls and puts into this current market, and while selling covered calls when you own the asset has its place and time, and the premium can look pretty tempting, selling calls can go very wrong if the underlying asset price takes off and leaves you in a world of hurt.

Selling uncovered puts isn’t covered unless you are short the asset and cover your puts with that, and being on the long side of this while selling puts is doubly dangerous because you have both positions punished by a big move down. This is why selling naked puts is generally seen as so risky, but people don’t realize that this is worse when you are long the asset.

Investors Have No Need or Reason to Worry About Options

The whole idea of typical investors, or anyone who calls themselves an investor instead of a trader, dabbling in options is odd enough, mostly because investors aren’t investing on timeframes where it really matters that much what happens in July, which is the focus of these current options recommendations that are out there now.

Emanuel is recommending investors sell August calls at 10-15% above the current market price, You can get 24 cents for selling calls expiring August 7 with a strike price of 15% higher than now, and $1.04 if you shoot for 10%, but neither of these has the “generous income” that Emanuel is telling us we’re in for. This is not just money handed over to us, and we’re on the hook if the price starts moving up that much, where we either will have to pay way more than this to cover our selling by buying puts, or take on all the risk should QQQ move past our strike price.

This might sound catchy to some people and some investors actually do sell covered calls, but this stuff is a zero-sum game and this is a lot like poker, as in if you are wondering who the fish are at the table are, you are one of them. It just doesn’t make enough sense for amateurs to be writing options of any kind, as this puts them even more out of their element than buying options does, and not something to ever do on a lark or because some guy tells you that this is a good idea.

Emanuel doesn’t stop there though, and also wants us to buy QQQ puts in the money and sell “further out” QQQ puts. This has us long the QQQ ETF, betting on it going down by buying the put, and collecting a little change if it doesn’t go up or by more than this 10-15% but potentially paying a lot if it goes outside this range. That’s a lot to get your head around for investors who are made dizzy by such a thing but not enough to not be able to reach into their pockets.

It’s not made clear what “further out” cashes out to but this will at least get you more than the pocket change that you would get from selling his out of the money calls he wants you to sell, which both pay far too little in comparison to their risk. Selling a 15% out of the market call gets you this 24 cents, but you can get almost 2 bucks for selling a put 15% out of the market, which not only tells us that options traders consider a 15% loss much more likely than a 15% gain, it also only pays chump change on the selling the call side.

No one should be tempted by selling this call, but if you sell the put, some may indeed be tempted at this much higher premium. Are you really that confident that the QQQ won’t drop this much by August 7 though? This number has been calculated by market participants that have a better idea of how things will go than typical investors, and if we are to have an edge here, it is only because they have a better idea of the price that this contract should be at then the market does.

There are options traders who actually are good enough to do this, but if you are an investor just taking trades from people like Emanuel, you are not among them, simply because you don’t have a proven record of doing this. Perhaps most importantly, you won’t have Emanuel holding your hand in the trade, as once you jump in, you are on your own. You certainly don’t want to treat any options selling as a one and done thing, because they can really blow up on you and do require skilled attention at various times, especially when the heat gets turned up on you.

He also wants us to buy puts at the money, which is at least a hedge and not trying to use options to speculate, and even writing them is speculating because you’re out to win money and not just prevent losses as hedges serve to do.

The problem with buying puts at the money is that they aren’t cheap, and costs $9.45 right now. If QQQ stays the same, you lose $9.45, and if you tailor your position to completely hedge this, this options trade still costs you $9.45 if QQQ goes up, which comes right off of your profits being long the ETF. They cancel themselves out on both sides and just yield the cost of the option. This is a great idea if you just want to lose the premium and spin your wheels otherwise, but if that’s justifiable, we should just save the premium as well and get out.

There is also no upside to this, no way that you can make a profit, although this does let you spin around the driveway for a little over a month basically. Not losing much is better than losing a lot, but this is a lot to pay for just a little over a month of hedging, if we can even call it this, and if you want to do it the next month you are going to need to pay a similar price for that.

Why investors would worry about where QQQ goes by August 7 unless it’s way down is the biggest question of all here. Even though this is a hedge and investors love to hedge, its scope is too short and its price is too high for investors to ever want such a thing.

Ultimately, if they really are out to hedge, and you can just hold the QQQ long term with no regard to hedging, and this investment has done fabulously and continues to do so, you could always just sell it when you really become worried, You might pay a little more tax but not so much that you may want to get hammered and lose several times more in capital losses, or the avoidance of them if you are wise enough to get back in when the panic ends.

We cringe a bit when we see these options recommendations being targeted toward people who are as far from options traders as you can get, and while there is real money to be made from these things, considerably more as far as returns go than investors aspire to, but you also need the chops to pull this off, and a wish and a prayer doesn’t count.

We don’t mind the idea of selling QQQ puts 10% out of the money as is suggested, but this is well out of the league of investors. The market for this option is certainly pessimistic with the premiums this high for 5 weeks, for instance with a strike price of $220 where you could grab $3.59 up front, but just knowing that this contract is overpriced enough to want to sell it now does not mean that this will remain the case.

We would need to keep a close eye on things, which includes not only how the asset is doing but how the overall outlook is, where recent fears may be holding it back right now a little more than it should perhaps. You need your eyes wide open and your hand on your gun to do this in a way that is competitive and potentially profitable overall, and we don’t want people who don’t know how to use a gun shooting themselves in the foot. This is for advanced traders only and isn’t even all that great of a play, but if we had to pick one of these, this at least wins by default.

This is one of the most difficult times in history to call the market, or QQQ which is a stock index, which means that it is especially important to stay within ourselves and certainly not pretend to be a good options trader, no experience needed. There are no hot picks with options like you see with stocks, only promising ideas, ones that need to be executed well when you’re in the trade as well to work.

The only real star of this show is the QQQ itself, which investors don’t give its due and could benefit a lot by looking at this index a lot more closely. The QQQ has left the other major U.S. stock indexes in the dust, and if Emanuel’s comments at least direct more investors toward the ETF itself, they will not be in vain.

Otherwise, beware of people standing on crates selling Dr. Feelgood. They may not be real doctors, and you may have to be one yourself.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.