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DO YOU INVEST IN options? Think twice before saying that you’d rather go to Vegas. My bold claim: Options investing has a lot in common with investing in stocks and corporate bonds.
Intrigued? Let’s recap a European style call option. It’s a discretionary contract that allows someone to buy an underlying asset at a set strike price at a future date. Let’s say the buyer of the call, Bob, has an option on a stock with a strike price of $100. Bob will only exercise the contract if it’s profitable. If the stock price rises to $150 by the time the option expires, Bob can acquire the shares for $100 and immediately sell them for a $50 profit.
On the other hand, if the stock price drops to $80, Bob has no obligation to exercise the option. His call option will simply expire worthless. Bob’s only chance at profit comes if the underlying asset clears the strike price.
That brings us to the option seller, Shelly. She owns the underlying stock and is participating in a covered call, meaning she’s selling a call option on an asset she already owns. In return, Shelly receives a call premium from Bob. Selling covered calls is a popular strategy for generating extra income.
In exchange for the income she receives from selling the covered call, Shelly risks having to sell the stock at the strike price. If the shares rise to $150, Shelly must still sell for $100. The covered call limits her payoff. If the asset doesn’t exceed the strike price, Shelly keeps her shares and pockets the income. What if the stock falls? Shelly still has her option premium, but that may be more than offset by the share price decline.
Now, let’s consider the positions of stock and bond investors in a hypothetical company called Contoso. You’ll see that their interests and chances for profit are quite similar to those of Bob and Shelly.
Contoso has just two investors: conservative Connie and risky Ricky. Contoso borrowed money from Connie, issuing her a bond with a $100 face value and a maturity date 10 years in the future. Similar to the premium income earned by Shelly, Connie will receive income while she holds the bond.
On top of the $100 from Connie, Contoso raised $100 in additional capital by issuing stock to Ricky, so the company now has total assets of $200. Ricky hopes that the company’s shareholder equity—which is the value of its initial $200 in assets minus its $100 in liabilities, as represented by Connie’s bond—will rise over time.
Fast forward 10 years to when Contoso’s $100 bond matures. The outcomes for Connie and Ricky hinge on how successful Contoso was in increasing its assets. If the company did well and its assets grew to $250, it can return $100 to Connie, leaving it debt-free, and its shareholder equity will have increased to $150. Result: Ricky’s stock would be worth $50 more than his purchase price.
Conversely, if Contoso struggled so badly that its asset base shrank below the value of its liabilities, the company might have to default on its debt. Its assets would be liquidated and Connie would keep the proceeds of the liquidation. If the assets are valued at $80, that’s what Connie would receive. Ricky, as a stockholder, would get nothing. There would be no shareholder equity left after the assets were sold off.
The financial position of Ricky and Connie resemble those of our options investors, with the face value of Contoso’s debt acting as the strike price. The value of Bob’s call option depends on the value of an underlying asset. Ditto for Ricky’s stock investment in Contoso. If certain hurdles aren’t cleared, both investors could come away with nothing.
Similarly, Shelly’s covered call position mirrors Connie’s experience as a bondholder. Both investors receive income and have limited upside. But their ultimate outcome also hinges on what happens to the value of an underlying asset.
Sanjib Saha is a software engineer by profession, but he’s now transitioning to early retirement. Self-taught in investments, he passed the Series 65 licensing exam as a non-industry candidate. Sanjib is passionate about raising financial literacy and enjoys helping others with their finances. Check out his earlier articles.
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Thanks Sanjib. I’m enjoying your articles. Browsing through some of your older ones as well. I often sell/write cash covered puts on stocks I deem worthy holding for the long term. These stocks are usually quality/consistent dividend payers. I feel during a downturn or with volatility, this may be as close to a win/win in the market that you could get. You either get a decent premium or collect a stock you deem valuable at a price you were willing to pay. Occasionally I’ll sell covered calls but really don’t want to loose my stable of dividend paying stocks if the market rips higher. I have on a few occasions performed the “Wheel Strategy” concerning options with stocks BX and WSM – sell a cash covered put, collect that premium, actually get assigned the shares, turnaround and sell a covered call on the assigned stock, collect that premium, get the stock called away, add up the profits in the collected premiums without risk of holding that particular stock long term. Again, I’m actual more conservative (buy and hold type) so my first strategy of writing/selling cash covered puts on what I feel are quality and consistent dividend paying stocks, and sometimes dividend paying ETFs, is my main strategy with options.
After many years of trading options, the only ones I do now are sell puts. I stopped doing covered calls ‘cos after a while I wondered why my portfolio was filled with mediocre companies. All the good ones had been called away.
Thanks Purple Rain. I think for experienced folks, selling OTM put is a good way to buy a desired security with additional margin of safety, while getting paid for being patient. I plan to write a piece on that.
Nice one, Sanjib. As I’ve been doing CCs and CSPs against the bulk of my portfolio for the past few years, I totally agree with your logic and approach. While no one is going to get filthy rich with a 1% return a month from writing low-risk options, it sure beats the alternative in a market like today’s.
Thanks, gregorit. I find the CBOE data on strategy benchmark quite interesting, especially the “risk-adjusted-return” aspects.