Options Trading for Value Investors

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Jake Reed


Jake Reed

Guest Post

written by

Jake Reed

Most value investors would not consider options and options trading as part of their investing strategy, but here’s where and how options can fit in.

Options Trading: Really!?

Derivatives, futures, FX trading, margin, options, and who knows what else?

All of these terms we have maybe seen before on our brokerage website or somewhere on the Internet. They all sound scary, complicated, and speculative. Another word that might come to mind is “gambling.”

Whatever “options” are, they’re absolutely -NOT- value investing. They shouldn’t even be in the same sentence.

Right?

Hear me out

As a value investor, how often have you found yourself in one of the following situations and been unsure how to proceed?

Situation 1: “Wish I could buy that…”

There’s a company you really like. You’ve looked into it and it passes practically all of the points on your checklist. You’ve likely analyzed it using OSV’s online app and maybe found that it’s a Munger stock, which means that it meets OSV’s criteria for Quality and Growth, but it’s sitting at or above fair value. In other words, a solid business you would be happy to own. It’s just too pricey for you and you aren’t comfortable with the current margin of safety you’d be getting if you bought today. To visualize where this theoretical company sits in relation to OSV’s three valuation metrics, I’ve put a big red dot in the image below.

Charlie Munger Quality and Growth Stocks diagram
Image copyright OSV

But let’s use a real example. One example today would be Clorox (CLX) which comes right up in OSV’s Munger Stocks screener with an action score of 80.7 (B). As you can see from the analyzer screenshot below, the price has significantly appreciated recently perhaps due to their potential profitability amidst the COVID-19 pandemic. They sell disinfecting products, after all.

Clorox is a good candidate for options trading

Before I explain how an option can help you out in this situation, read on to situation 2.

Situation 2: “I’d like to sell this stock, but…”

Now suppose you’re on the other side of the equation. You bought a company some time ago, and the price just has not appreciated like you thought it would. Maybe the company had a bad quarterly earnings report, macroeconomic events (like COVID-19) impacted margins, or the company is involved in some serious litigation. The price went down, and you see no clear catalyst for the company to recover from its malaise. At least for a good long while. In short, you’re in the unfortunate position of feeling you may have to sell your shares at a loss. Otherwise, you could hold onto them and hope that your original thesis will play out in the long term.

So how can options help you get out of these binds? I’m glad you asked.

So what are Options then, and how do I use them?

Next, let’s go over the basics of what options are.

Essentially, they come in two varieties: a “call” and a “put.” There are a plethora of resources online that you could read to familiarize yourself with the basic – and advanced – concepts further, but what is outlined here should be enough to get started – and help you out in both of the situations from above.

To put it simply, call and put options trade just like companies in the stock market. That is to say, you can buy or sell them during market trading hours through a brokerage service and their prices change with the vicissitudes of Mr. Market just like companies.

The owner or buyer of a “put” option is buying the right to SELL a certain number of company shares at a set price (called the “strike price”) before the option expires (called the “expiration date”), while the owner or buyer of a “call” option is buying the right to PURCHASE a certain number of shares of a company at a set price before the option expires.

Here’s an example I’ll use for illustrative purposes to explain a couple option strategies that can be used in the two situations described in the beginning of the article.

Note: I did not actually perform a fair value analysis of DIS for the example. The fair value numbers are for illustrative purposes only. However, the option premium values are accurate as of writing.

Disney (DIS) is now trading around $109 per share.

Arthur buys a single put option of Disney (DIS) at a strike price of $90 that expires on October 16th, 2020.

That means that Arthur has purchased the right to sell 100 shares* of DIS at $90 on or before the market close on the expiration date of October 16th, 2020. For this option, Arthur had to pay a premium of $4.30 per share, or $430 total. He was happy to do this to protect his investment through October 16th, because he absolutely does not want to sell his investment for any less than $90.

On the other end of this deal is the option seller (let’s call him Phil). Phil is the one who has the obligation to buy Arthur’s 100 shares of Disney if the price drops to or below $90 dollars (no matter how far it goes). Phil, however, does get to keep that $430 premium from Arthur in exchange for taking on this risk.

*One option contract is equal to 100 shares minimum

Situation 1: Cash-secured put

So what do you do in this situation? Do you just buy the company and forget about the price? Most value investors I know would just wait until the price came down to the level they like.

But what if I told you that you could get paid to wait for the price to drop? And that if the price never dropped to the level you desired, you’d still get paid anyway?

You can absolutely do this with an option strategy called a “cash-secured put.” Referring back to the example Put option using Disney above, let’s make some assumptions:

  1. The price of DIS is around $109
  2. You want to own DIS, but don’t want to pay $109 a share.
  3. You think DIS is below fair value at $90 and are comfortable buying the company at that price
  4. You have at least $9000 in your brokerage account to actually buy 100 shares of Disney at $90/share (the “cash-secured” part)

In other words, you are “Phil” in the example above, and you would sell a put option at the $90 strike price for a premium of $4.30 per share ($430 total). This money gets added to your account along with your $9000, giving you $9430. This represents about a 4.8% return over the 5 months between now and the option expiration date.

However, you now have the obligation to buy those 100 shares of DIS if the price falls to or below $90/share. But you’re not worried about that, because that’s exactly the price you’d be happy to buy DIS for.

What if the price doesn’t drop to $90 or below and stays the same or even increases? Then the option you sold will expire worthless on October 16th, you keep the $430 option premium, and you can use the cash to do a similar strategy or something else entirely.

Situation 2: Covered Call

So how about situation 2? You own shares of a company that you like, and you have a price you would be happy to sell it at. In the Disney example, imagine instead that you are Arthur with the following assumptions:

  1. You own 100 shares of DIS with a buy price of around $100/share
  2. The current price is $109, but your fair value estimate is around $130, which you would be happy to sell your shares at if the price appreciated

Instead of simply waiting for the price to move up, Arthur instead chooses to sell a “covered call” here. It is “covered” because Arthur owns the 100 shares he would be obligated to sell if the price of DIS went to or above the strike price of $130). As a matter of fact, if Arthur sold a call expiring on the same day, October 16th 2020, against his 100 shares, he would collect a premium of around $3.00 per share, or $300. This represents about a 3% return on investment in 5 months – significantly greater than Disney’s dividend yield of about 1.6% as of writing. The fact that Disney suspended their dividend recently due to COVID-19 makes this option strategy all the more appealing to Arthur.

One other benefit the covered call has is that it actually plays into the idea that an investor should have an exit strategy for any position entered. Sure! And why not collect a premium on the way?

Sounds too good to be true. What’s the catch?

Writing (selling) options carries risk that is not suitable for all investors.

That is why I personally only engage in what options traders call “risk-defined trades” like the two strategies outlined above. In a “cash-secured put” strategy, your maximum loss is the cash you invested, just as if you bought the shares outright. In the “covered call” option strategy, your maximum loss is missing out on price appreciation that occurs beyond your selected strike price.

Also, in the cash-secured put strategy, the cash you have set aside to buy your chosen company can’t be used for anything else. So if a better alternative comes along while you’re waiting and you change your mind before the option expires, you would have to buy back the option contract to free up your cash again, which could be more or less than the premium you received depending on how the price of the option moved. To put it another way, there is potential opportunity risk with this strategy.

For the dividend growth investors out there, a huge downside to options is this: options ≠ stock. This means that even if you sold a cash-secured put on a company that pays a dividend, you are not considered a shareholder in the company until and when that option is exercised at the strike price, forcing you to buy the shares. In short, to be entitled to a company’s dividend payments, you actually have to own shares – not just “potential” shares at a future date.

While it isn’t really a “catch,” it is also worth noting that option premiums received by option sellers are subject to short-term capital gains tax rates.

Before selling options, it is wise to familiarize oneself with the tax implications of the aforementioned strategies by performing due diligence or consulting with a tax advisor. This is especially true for those who already receive a lot of income each year from dividends or who made large capital gains from selling shares in any given tax year.

Conclusion

Options can be as simple or as complicated as you want, and sophisticated options folks have all sorts of funny names for the various types of strategies employed.

But don’t let that scare you. Rather, I would encourage value investors to see selling options as just one more potential tool to use for the all-too-common situations that I mentioned above. Of course, there are countless other situations where buying or selling options can give you an edge in any type of market.

If you found this useful/informative, look out for another article on the buy side of options for value investing in the future.

Happy investing.

Disclosure

Options are not suitable for all investors and can carry unlimited risk. The author is not recommending any particular companies or trading strategies and the examples are for informational purposes only. The author has no positions in any stocks mentioned in the article and does not plan to initiate any positions in stocks mentioned within the next 72 hours.



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