28 August 2020 | Eugene Ng | Founder & CIO | Vision Capital
Introduction
I receive this question fairly often in different variations. Do you use options or employ any options or derivatives when it comes to investing? How about sell covered call options or sell put options? The short answer is no.
Let’s make an attempt to explain these first, and then detail out why we do not in Vision Capital.
Introducing Options
There are plenty of ways to profit on a stock’s movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
A call option is an options contract that gives the buyer the right to purchase the underlying security at the specified strike price at any point up until expiration. A put option is an options contract that gives the buyer the right to sell the underlying asset at the specified strike price at any point up until expiration.
We will cover two of the latter and the more frequent basic income earning strategies, (1) selling covered calls and (2) selling puts.
(1) Covered Call Options
A covered call is constructed by (1) holding a long position in a stock and then (2) selling (writing) call options at higher strikes on that same stock, representing the same size as the underlying long position.
This is an options strategy typically used when you already own a stock and would like to generate more income / higher returns from your existing investment.
Gains come from two sources. First, the premiums received from writing (selling) the call options. Second, the gain in share price between the buy price and the strike of the sell calls when the covered call is eventually exercised.
Covered call is a popular options strategy used to generate income from investors who think stock prices are unlikely to rise much further in the near-term.
When the underlying stock price stays below the strike price by expiry date, you end up receiving the option premium and the options you have written expires worthless. Your additional gain will be purely the option premium received.
Conversely, when the underlying stock price rises above the strike at which you sold the call options, that’s when the call options will be exercised against you and you end up having to sell the stock at the strike. Your gain will be the option premiums received in addition to the difference between your lower entry price and the higher strike price of the sold calls.
So for example, you have bought a stock @ $10 and sold 1 month expiry call options at strike $12 and receive 5% option premium (i.e. $0.05).
If the stock price stayed below $12, you have received $0.05 for 1 month’s effort. If you could replicate this continuously at the same for 12 months in a row without any calls being exercised against you, you can receive an additional $0.60 ($0.05 x 12). That’s an additional 6% return per annum. Not too bad for some work every month.
Now, if the stock price goes above $12, you end up having to sell at $12, and your total profit is $12 + $0.05 — $10 = $2.05. But what if the stock price went much higher than $12 to $15 or to $20?
One, you end up beating yourself for foolishly selling options and limiting your upside. At $15, your missed opportunity of profit is $5, a 50% return and at $20 if the stock doubles, the missed profit opportunity is then $10 or a 100% return.
Two, you are likely to be psychologically very hesitant to re-enter to chase, buy and hold the stock at such elevated prices. That makes things very difficult.
A covered call will limit the investor’s potential upside profit, and will also not offer much protection should the price of the stock drops.
So, write covered calls when:
- You would sell a stock that you own at a higher price, and you are not worried about it declining too much in the meantime. Write calls at your desired sell price, collect the income (option premiums), and kick back, relax and wait. Rinse and repeat, month after month when you can.
- You believe a stock you own is going to stagnant for a while, but you don’t want to sell it right now. Write calls to make the stagnation more profitable.
- You want to cushion a stock that is in decline, but that you’re not ready to sell yet. Tread carefully here so you don’t get sold out at too low a price.
Ultimately, we are investing in companies for the long term, and we don’t have a short or medium term view of where the prices of our investment holdings will be. We do not claim to know or try to find out, and that makes it very difficult to try and time the market and sell covered calls. We don’t know where the market is going to go in the near-term, but one thing we can tell you for sure, where it will go over the long-run.
In addition, when we invest, we are looking for multi-baggers over a long period of time, stocks that return 5–7X over 5 years, 10–20X, 50X or even 100X, not companies whom we expect prices to not rise. Selling covered calls that earn these very little option premium in our opinion, presents very little upside and limits all our further upside. It is the biggest downside to covered calls, the lost potential of gains if a stock price rises much much higher.
In all, it is not that Covered Calls is not a good option strategy to enhance one’s investment returns, it is just not the right strategy for us to employ because of the way we invest.
But, if you are holding a blue-chip investment portfolio where companies are typically maturing and experiencing low single digit revenue and profit growth and likely low single digit returns as well, this could be an appropriate strategy you can look at in greater detail and these companies tend to have stable stock price returns over the short/mid/long term.
(2) Sold Put Options
Selling puts, also referred to as selling naked puts is a commonly used strategy of mine to seed a portfolio. There may be plenty of stocks that you would like to buy at the start, but prefer to buy them at lower prices. Put options is a alternative approach to potentially buy a stock at your desired, lower share price and get paid an option premium while waiting for that price, whether it arrives or not.
Let’s turn to an example: A stock is trading at $39, you are looking it to buy it at $35 and below. The $35 put options expiring four months out are paying $3 per share. You “sell to open” the put contracts and get paid $3 per share option premium to make the trade, giving a potential net purchase price of $32 before commissions. A few things could happen here.
Scenario 1: The stock could stay above our $35 strike price, and the options you sold expire worthless. You didn’t get to buy the stock at the price you wanted, but at least you made money on the options we sold. But again what happens, if the stock rises significantly now to $40 to $50 or to $60? Similar to the Covered Calls, the biggest downside to selling puts, the lost potential of gains if a stock price rises much much higher.
Scenario 2: The stock could fall below $35 by expiration. In this situation, you would buy the stock at $35 but with a $3 option premium, your effective entry price is $32 before commissions, even lower than your $35 desired buy price!
Scenario 3: The stock may tank to $29 soon after you sell the puts, but then climb back above $35 by expiration. In this case, you most likely would not have had the shares sold to you during this brief decline because typically majority 80% of options are exercised only at expiration, not before. So you won’t own the shares and you would have missed your buy price and the stock’s rebound — but you did get paid the premium, at least, and can try again. In a worst case scenario, where the stock price keeps rising, you only miss out buying the stock, and accordingly the much returns upside despite receiving the regular option premiums.
Scenario 4: The company had fraud and the stock falls massively and is only at $16 by your option’s expiration. You did not have the heart to close your losing option position, and whilst you still have hope, so you wait and the shares are “put” to your account at $35 (minus your option premium) upon expiration. This is the worst-case scenario — you are down 50% to start. But you own the stock now and can hope it rebounds. Of course, assuming that you would have bought the stock outright when it hit your $35 buy price, as you had considered, you would be down even more than we would be with this strategy.
Writing puts on stocks you know well and want to own at lower prices and can be an excellent tool for income and for securing lower buy prices, but you must be prepared to buy the stock should it fall below your strike price. At all times, you must maintain the cash or margin to buy shares if they are put to you. It is important that you only write puts on stocks that you understand well and will be happy and ready to buy at the prices you’re targeting.
The risks of writing puts include the fact that the stock could soar away without you. In many cases, more often when we are investing for multi-baggers, it is far better to just buy a great stock once you’ve found it. The other risk, of course, is that a stock falls sharply and you’re stuck owning it. The biggest risk with selling puts, as with all options, is when investors use rely on margin instead of cash. That can quickly wipe out a portfolio.
To Close
Selling covered calls on existing bought positions and selling naked puts for new positions are common income generating strategies used by the market. It can be very rewarding to earn regular income and can potentially have a very high probability (typically ~70–95%) of earning such additional income.
But the common theme in both strategies is really more about the upside for us, not the downside. Specifically that the upside is often limited (not that it is not good), and we do not want to cap our upside when we are investing for multi-baggers (where it comes to selling covered calls) and not being unable to own the companies (selling puts never get exercised), and these companies keep running away from us.
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