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Options vs. Stock


arbitragr
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Hi all,

 

I know some of you like to allocate capital via options. I just wanted to get the scoop on the pros and cons of each.

I'm thinking about taking an options position. In the past I've never had the courage to, because the capital that I put up is quite large and would only want to make absolute sure things will work out, and also that options relates to three things: time, volatility, and price. I might get the last one right, but I don't know anything about the former two variables.

I've tried options in the past but haven't been successful b/c as time wears on, the option value would diminish (this is for a LEAP position).

 

Options is just like buying stock with leverage, only a bit cheaper ... is it not?

 

Please enlighten me.

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Guest kawikaho

Options are contracts.  Probably started like this some many years ago: you go through many winters for many years buying firewood for, on average, $10 per ton (enough to heat you through winter).  Then one year, there is a big fire, and all of a sudden, there's barely any firewood left and prices shoot up by 2x.  You can't afford the new prices, and have enough firewood to keep you warm at night, but freezing in the day.  After this happens a few times in your life, you realize there has to be another way.  You realize it might be better to have some insurance, a contract, with the firewood sellers.  You approach them and say, "I'll pay you guys a year in advance for the option to buy this firewood at $10/ton.  I'll pay you $1/ton to do this.  If you have a surplus of firewood and sell for a cheaper price, I'll just buy it at the cheaper price and you guys still have the money I paid you for the contracts.  If the price goes way above this $10/ton price, I have the option to buy it at $10/ton.  If the price stays at $10/ton, you keep the $1/ton contract, and I paid in total $11/ton.  The firewood guys probably think this is a good idea for them, because they average maybe one firestorm every decade or more.  Options are then born.

 

The whole idea is, in effect, insurance. 

 

The best ways to use options is as a hedge, or insurance, or to short since you limit your upside risk to the premiums, or in very volatile stocks.  I used them twice recently in shorting GM and CIT.  In both instances, the options value increased 76% in less than a month. 

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Calls options have an embedded put option that makes them very appropriate for certain types of positions.  I love how "sophisticated" strategies involve selling covered calls which adds lots of liquidity and keeps prices rather reasonable.  Valuation models for options don't take intrinsic value as a consideration, its like playing poker against players that don't check their hole cards. 

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So correct me if I am wrong ... Going long by taking a position in a LEAP probably isn't the smartest way to go long? Since there are uncertanties regardind timing (i.e. time decay of option over the life) and volatility?

ie options are best just left for hedging? especially if the contracts are cheap?

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Options are very different than long stock, though LEAPs are much closer to long stock than shorter term options.  With short term options, a 5% move in a stock can effectively wipe out 100% of your investment.

 

I think options can be used to hedge, but are also effective as a speculation.  There are a variety of strategies, on both the long and short side.  When you start combining multiple option and stock positions, it can get confusing.  You should understand how different positions combine and what your equivalent long/short position is.

 

For example, possibly the most common options position is a covered call -- buying shares and selling calls against those shares, then waiting for the sold options to expire.  A surprising number of people seem to believe that in this situation, the best result is for the stock to stay flat or fall a bit, so that the options expire.  However, this position is equivalent to being short a put, so truly the optimal result is the stock to skyrocket instantly, so that the position can be closed out the next day at a high annualized return.

 

Generally, I'd say that there are two strategies, hitting singles by selling options and pocketing the premium when the options expire (like the covered call strategy), or going for homeruns by buying options.

 

When selling options, a key thing to understand is that one big loss can wipe out a lot of gains.  e.g. suppose you'd been selling AIG covered calls a year or two ago when the stock was at $60.  You might have got $2 premium for a short term call.  Maybe you did this 3 times, making $6.  Then the stock fell to $2.  Then, you've basically lost $52 (and also can't sell more calls at a reasonable price with the stock at $2).

 

One interesting way around this problem is to sell longer term options.  Then you bring in a lot of premium, protecting the downside, but the annualized return isn't as great.  But returns can still be good, particularly if the stock moves up quickly and you can close out the position early.

 

The first thing to understand about long options is that it isn't uncommon to lose 100%.  Even if you say that you're going to sell after a certain time period -- before hitting the worst of the time decay -- if the position moves against you, you can lose money quickly.  So, the strategy you chose should be robust enough to handle a string of huge losses. 

 

Thus, the key to long options (and maybe short options too) is money management.  You want to invest far less in an options position than in an equivalent stock position.  It would be very stupid to have 50% of your portfolio in call options, because the market could go down for 2 years, and you'd lose that 50%.  One reasonable way to play long options is with 90% cash, 10% in options, with a rule that you can only lose 10% in one year.

 

I think generally, one should aim for 400%+ returns on long options.  Then, if you win once for every two losses, you're still doing well.  You might be able to get away with smaller returns on LEAPs, since your winning percentage might go up.  But generally, I think the right strategy with long options is to try to win big. 

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Volatility is less of an issue when buying options.  The primary concern is always the time arbitrage and the price you pay for them.  Eventually, the options are worthless if not in the money, thus understanding the actual operations of the underlying business in the relative short-term is important.  There is definitely a speculative nature to it, so you have to make sure you understand that.  Your batting average will be significantly lower, but the payouts are much higher if you can find inefficiencies in pricing. 

 

It's also a very good way to mitigate short-term market risk...such as you buy a basket of call options in place of a basket of equity positions in a leveraged business.  You could take four or five 5-10% equity positions or four or five 1-1.5% call option positions.  The maximum you have at risk is significantly smaller, but remember that if you are wrong on all five positions, your options will be worthless at maturity.  Cheers!

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70% of options expire worthless, & most of the other 30% simply breaks even. Worse still is that for every big ‘win’ with a 5-10% P(x) of occurring, you need the win to be at least a 5 bagger just to recover your losses. You sell options – you don’t buy them.

 

A call option is simply a mechanical limit order – so why are you paying someone else to do what you can already do very easily ? And if you already have the cash to buy at ‘X’ - isn’t the return that you’re paying really the premium x 12 months/option period x 70% + the 12 month T-Bill rate. There is a reason to the madness.

 

The best option is often the longest dated option, but you can’t borrow against any interim ‘gain’ & its not liquid if it goes deep in the money. If you’re long the underlying you can do both, & you still have time to bail you out if the price falls the day after you buy.

 

There is a place for options (ie: hedging your employment with puts on a competitor of the company that you work for) but it should be a fairly rare event.

 

Not text book

 

 

SD   

 

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70% of options expire worthless, & most of the other 30% simply breaks even. Worse still is that for every big ‘win’ with a 5-10% P(x) of occurring, you need the win to be at least a 5 bagger just to recover your losses. You sell options – you don’t buy them.

 

A call option is simply a mechanical limit order – so why are you paying someone else to do what you can already do very easily ? And if you already have the cash to buy at ‘X’ - isn’t the return that you’re paying really the premium x 12 months/option period x 70% + the 12 month T-Bill rate. There is a reason to the madness.

 

The best option is often the longest dated option, but you can’t borrow against any interim ‘gain’ & its not liquid if it goes deep in the money. If you’re long the underlying you can do both, & you still have time to bail you out if the price falls the day after you buy.

 

There is a place for options (ie: hedging your employment with puts on a competitor of the company that you work for) but it should be a fairly rare event.

 

Not text book

 

 

SD    

 

 

well, I wouldn't say that the best option is the longest dated one, but rather, the most mispriced... if we have SHLD $60 options that expire in jan of 2010 and 2011- with the 2010 one selling for a penny and the 2011 option selling for $500, you would be hard pressed to not buy the 2010 contract. Granted, this is a pretty extreme and hypothetical example.

 

I certainly agree that options do have their place in some people's portfolios.

 

the idea of hedging your employment is pretty genius.

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"There is a place for options (ie: hedging your employment with puts on a competitor of the company that you work for) but it should be a fairly rare event".

 

 

Some explanation:

 

Virtually all employers treat employee hedging (of their stock) as a firing offence - but it is illegal to prevent an employee from buying puts on a competitor. The typical arrangement is a Memorandum of Understanding, monthly statement disclosure, long ABC coy employee options, and short XYZ coy via the put. You agree to bleed a little every quarter, to make a profit if XYZ coy experiences difficulties - identical to Taleb.

 

Assume that you worked for a Cisco, & per common practice you're awarded 40% of your salary in options. If Cisco does well you will too, but because its a big part of your comp you don't necessarily want it adversely exposed to the market. Nortel is a direct competitor, & pretty much the same business conditions that affect Nortel will affect Cisco, & about the same time. Therefore buy the equivalent number of Nortel puts.

 

Everybody keeps buying tech, the earnings & stock price are up, & Ciscos bonus cash rains upon you. The cash bleed is easily affordable & the puts get rolled up & out to minimize the decay loss.

 

But when everybody stops buying ... Ciscos earnings & share price drops, & it pushes the sectors multiple downward, affecting Nortel. The sectors share prices go into a feedback spiral, & all those employee options go into the toilet. If it spirals long enough; there are eventually mass layoffs, asset sales, & potentially bankruptcy.

 

Except that you got to stay rich because you were hedged, & those same conditions have driven your puts very deep into the money. You also have the exchange as your counterparty, vs someone else in the industry who may not be able to pay.

 

.. And if the scale is big enough, pehaps you even have enough to take out some of those assets !

Old skule WEB

 

 

 

 

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"There is a place for options (ie: hedging your employment with puts on a competitor of the company that you work for) but it should be a fairly rare event".

 

 

Some explanation:

 

Virtually all employers treat employee hedging (of their stock) as a firing offence - but it is illegal to prevent an employee from buying puts on a competitor. The typical arrangement is a Memorandum of Understanding, monthly statement disclosure, long ABC coy employee options, and short XYZ coy via the put. You agree to bleed a little every quarter, to make a profit if XYZ coy experiences difficulties - identical to Taleb.

 

Assume that you worked for a Cisco, & per common practice you're awarded 40% of your salary in options. If Cisco does well you will too, but because its a big part of your comp you don't necessarily want it adversely exposed to the market. Nortel is a direct competitor, & pretty much the same business conditions that affect Nortel will affect Cisco, & about the same time. Therefore buy the equivalent number of Nortel puts.

 

Everybody keeps buying tech, the earnings & stock price are up, & Ciscos bonus cash rains upon you. The cash bleed is easily affordable & the puts get rolled up & out to minimize the decay loss.

 

But when everybody stops buying ... Ciscos earnings & share price drops, & it pushes the sectors multiple downward, affecting Nortel. The sectors share prices go into a feedback spiral, & all those employee options go into the toilet. If it spirals long enough; there are eventually mass layoffs, asset sales, & potentially bankruptcy.

 

Except that you got to stay rich because you were hedged, & those same conditions have driven your puts very deep into the money. You also have the exchange as your counterparty, vs someone else in the industry who may not be able to pay.

 

.. And if the scale is big enough, pehaps you even have enough to take out some of those assets !

Old skule WEB

 

 

 

 

 

so why not buy puts on a sector ETF to offset industry style slowdowns, while buying call options on a competitor. That way, you can offset the event of your company going belly up, while the other company does well (say, what happened to best buys stock price when ciruit city went bankrupt).

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So correct me if I am wrong

 

You're wrong :-).  I will elaborate a bit later.  I have been using Leaps extensively for two to three years now, mostly with success.  A.

 

+1

 

I'm with Al. I disagree with alot that has been posted here. Particularly as it relates to leaps on a stock like FFH. I have had great success including very recently. I use the leaps in combination with long positions to increase my effective exposure. My leaps that are well in the money will be converted to common on expiry or just before to capture the dividend in 2011. I don't purchase anything but the longest available leaps.

 

I've had occasion to use the leaps to deal with a margin call whereby I had to sell some common but wanted to have effective exposure to the same or more shares as the margin calls only came at times when the price got silly with respect to intrinsic value (2 or 3 times in the past 6 years). In the times this has happened I took the opportunity to increase my exposure significantly with leaps and benefitted in a big way from the temporary drop in price and margin call that would have average joe go into fits of panic if he didn't understand the value.

 

My deep in the money leaps also are marginable in a similar fashion to common though more conservative math is applied by TD.

 

Lastly, when I buy a leap I am consciously deciding that I would be very comfortable buying the stock for that price at expiry. When intrinsic value and ultimate long term ownership of increasing quantities of shares are taken into consideration the traditional means for valuing options goes out the window. It is why we have seen so many opportunities with FFH leaps over the years including one ridiculously attractive opportunity a couple of years ago that many here participated in.

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A bit of background:  I started learning about options from members on this board:  primarily Ericopoly,  Mungerville, and Numquam Perdo.  My first option trades were buying January FFH 2008 Leaps back in the summer of 2006.  This was very successful and led me to explore other possibilities.  Since then I have held put options on the S&P 500 (options on the SPY etf):  The positions were intiated in the spring of 2008 around when BS was imploding.  I had a few with December 2009/2010 expiry.  I sold most of these at a profit early in the fall of 2008.  Had I waited I would have done better, obviously.  I actually sold the last about three weeks or so before FFH  announced they were removing their hedges.  Mine were intended in part to be a hedge and in part to bet that the market was going to go down. 

 

Since my initial success with the FFH Leaps I have renewed and advanced the position whenever the stock fluctuates.  At higher stock prices I have sold FFH Leaps with short dates and bought back at longer dates when the price drops.  At the present time I hold about 30 FFH Leaps for January 2011 and a couple left for January 2010.  Sometimes I take a some losses to ensure long term gains using this strategy.  Keep in mind that I am doing all of this using US options, but in Canada where there is no distinction between holding periods for tax reasons.  I have also bought put options against FFH to protect my gains to avoid taxes.  This has not worked as well and I have opted just to hold smaller positions. 

 

Last November I started to buy SPY etf leaps.  I bought them at SPY 100, 95, 90... and later in March at 85 80, 75, and 70.  The initial ones had an expiry of Dec. 2010, later ones Dec. 2011.  This is where I will discuss the downside.  My earlier purchases, some of which I did not sell into the January rally, were worth zero on March 8th, not a very pleasant prospect, but I had sold some in the winter and on the way down, at a loss, which gave me cash to buy other, cheaper units when the prices got unbelievably low for the Leaps. 

 

In the winter I purchased Leaps for the following:

AXP, GE, MFC (Canada), SPY, WFC, HD, and SBUX.  All are in the money as of today, and all have a 1.5 years to expiry.  However, I will never buy another option from a Canadian exchange (there is no liquidity) and the spreads are huge - this is for Manulife which is one of Canada's biggest companies.  I have had a few that have not perforned as well that I got out of quickly such as MCO, and a couple that have expired worthless. 

 

Like Mark I use Leaps as a proxy for not being able to buy enough common shares of a company, or not wanting to commit as much capital to something,

 

A basic summary:

1) I buy Leaps of companies I would be happy holding anyway

2) I pay careful attention to expiry dates and times.  They will almost certainly drop in price when when the next years issue arrives.

3) Buy at the point of maximum market, or company dislocation.  This sets one up for a maximum return.  Today, I can buy GE Jan 2011 12.50 Leaps for about 2.25.  The stock is at 11.70.  That gives me a break even stock price of  14.75.  What are the odds that GE will not be trading above 14.75 somewhere before January 2011 - My bet is pretty low.  I am figuring at least 25 for a gain per leap of at least $10.  Unfortunately I wont get that for all of them as I will sell some on the way up. 

4) As with common stocks take advantage of absurd price dislocations.

5) Sell on the way up... dont wait for the perfect buy or sell points.  As you make money unload the damn things.  GE may well reach $40.00 in 1.5 years but I will be out of nearly all my options before then.  I may convert a few thousand to shares along the way. 

6) I only buy extremely liquid positions.  The spreads on GE options are often only 2-5 cents and they trade hundreds of contracts per day. 

7) I dont bother with sophisticated math for any investing let alone options.  By this I mean options pricing formulas, discounted cash flow, or any other ridiculous formulation designed to explain the impossible to explain.  I guess like other value investors, if it takes too much analysis it goes into the too hard pile.

 

Today, I wouldn't buy options on the SPY etf, SBUX, WFC, or AXP or much else that I know well.  I would still buy GE, and HD, if I hadn't.  I will buy FFH leaps for 2012 when they come out, if the price is still below 300 US. 

 

My thoughts and experience only... not advice. 

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Okay great guys, thanks. Much appreciated.

 

So then, with the mechanics out of the way ... so why not just go long on the stock then and bet big?

i.e. I could never bet big with a leap, like I do with BRK/A. Full conviction, with some leverage too?

What are the advantages of options/leaps over stock, if you're not using it to hedge.

 

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Arb, I guess my answer to that is that the implied leverage in the Leaps I hold allows me to indirectly hold 2 million in stock.  The easy upside is 1 million dollars gain... the downside is an unlikely but obvious zero.  As Flying Arrow indicated, there is room to hold lots of common stock as well so the downside is not actually zero.  It's all about risk management. 

 

At some point perhaps today the masses are going to reenter the stock market and drive prices way up, at which point us value investors will be forced out to the fringes again, and the easy pickings will be done.  Make hay while the sun shines. 

 

These are relatively rare opportunities at extremes.  I wouldn't buy options of WFC because the movement from this point upward is likely to be much slower. 

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Arb, I guess my answer to that is that the implied leverage in the Leaps I hold allows me to indirectly hold 2 million in stock.  The easy upside is 1 million dollars gain... the downside is an unlikely but obvious zero.  As Flying Arrow indicated, there is room to hold lots of common stock as well so the downside is not actually zero.  It's all about risk management. 

 

At some point perhaps today the masses are going to reenter the stock market and drive prices way up, at which point us value investors will be forced out to the fringes again, and the easy pickings will be done.  Make hay while the sun shines. 

 

These are relatively rare opportunities at extremes.  I wouldn't buy options of WFC because the movement from this point upward is likely to be much slower. 

 

Yes it's about leverage. Two weeks ago I sold 300 FFH common in my SDRSP and bought 10 2011 calls which represents economic interest in 1000 shares instead of 300. You do the math over the last two weeks and you'll see why I am happy. I intend to hold for a very long time but rather than hold 300 I believe I will eventually hold 1000. I've been less inclined to pull the trigger and sell like Al.

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Hi Arbitragr,

 

You can use options either for leverage or to manage risk.

 

To use options for leverage, you need to get both the direction of the move and the timing right. Get both right and you make a great % return; get it wrong and you lose a high %. I am not competent enough to time markets so I avoid using options this way.

 

However, I think options are a great way to manage risk. Some examples:

 

a) When option prices are low (when implied vols are low), I do option/fixed income combos as an alternative to an outright stock purchase. E.g. Instead of investing $250 to buy FFH stock (when FFH was $250), I would buy FFH 250 2011 calls for $50 and invest the balance of $200 in ORH A pfds at $17 yielding almost 12% with good potential for capital gain. Come 2011, assuming ORH does not go under, I will still have approx $250 even if the FFH calls expire worthless. I have foregone two FFH dividends but that's a small price to pay for the comfort of taking away the downside risk of a large FFH position.

 

Options of less volatile stocks like JNJ or PM are even cheaper (about 7.5% annualised premium to expiry) and work very well at times like these when fixed income yields are relatively high.

 

b) When FFH experienced the short squeeze last year, I was long both FFH stock and LEAPs. I suspected that the price spike would not last but, lacking confidence in my ability to time markets, sold my stock and replaced them with FFH calls. By doing so, I retained the upside but had now locked in my stock gains. Because option volatilities and therefore premiums were high, I also sold some short term out of the money calls and puts to partially offset the cost of buying the calls. (The spike in implied vols was much greater for short dated options than for the LEAPs).

 

c) When the market was in meltdown mode in Q4 08 and also Q1 09, and it seemed like everything was going under, my analysis suggested that Blackstone (BX) would survive. Not having 100% confidence in my analysis, I decided to buy the LEAPs instead to minimise my potential loss.

 

d) Another possibility - say you want to take a very large position in FFH (>50% of your portfolio). A way to reduce your risk is to buy FFH calls (for the same notional amount so that you are not leveraging up). If you then sold puts to pay for the cost of these calls, you would in effect have created a synthetic long position in FFH equal to that of buying FFH stock. This exposes you to the same downside risk of buying the stock outright. However, if you instead sold puts on a basket of stocks, you can retain the full FFH upside without taking the same company specific downside risk exposure. You have achieved the same concentrated long exposure while diversifying away your downside risk.

 

There are many different permutuations depending on what your objectives are. The one thing I would add is that I am more inclined to be a buyer rather than a seller of options for the reason that selling generally exposes you to risk for limited compensation.

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Arb, I guess my answer to that is that the implied leverage in the Leaps I hold allows me to indirectly hold 2 million in stock.  The easy upside is 1 million dollars gain... the downside is an unlikely but obvious zero.  As Flying Arrow indicated, there is room to hold lots of common stock as well so the downside is not actually zero.  It's all about risk management. 

 

At some point perhaps today the masses are going to reenter the stock market and drive prices way up, at which point us value investors will be forced out to the fringes again, and the easy pickings will be done.  Make hay while the sun shines. 

 

These are relatively rare opportunities at extremes.  I wouldn't buy options of WFC because the movement from this point upward is likely to be much slower. 

 

I would add that the leverage is less dangerous.  If you're using traditional leverage, you have to deal with margin calls, being forced to sell at inappropriate times, and you can ultimately go broke.  You can only go broke with options if they all actually go to zero.  Not as safe as pure equity on the time-scale, but better than raw leverage in my experience, at least if you're dealing with LEAPS.

 

You could still get burned of course, but you'll never get burned to the tune of massive negative equity.

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We use options exclusively for hedging purposes,

& almost always as the option writer.

 

As a put writer we generally prefer shorter term options at the money, & write with a view to acquiring the underlying. Greeks are important to us, & the premium is the consolation prize if we fail.

 

We will occassionally sell a position & hold the T-Bill +long call equivalent. Allmost always around binary events where there is an upward bias, but the outcome could go either way. The premium is insurance.

 

We find the biggest advantage of being long the underlying is the flexibility. Certainty, today, every time we do a buy/sell. More secure lending vs premium income. Borrow capacity every time we need it. No forest of potentially adverse forward obligations.

 

We also snore very soundly every night  ;D

 

SD

 

 

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Hi Arbitragr,

 

You can use options either for leverage or to manage risk.

 

To use options for leverage, you need to get both the direction of the move and the timing right. Get both right and you make a great % return; get it wrong and you lose a high %. I am not competent enough to time markets so I avoid using options this way.

 

My thoughts exactly. The timing part is hard, that's why I'm less inclined to make big bets with LEAPS.

I do hedge however, I use predominantly futures to hedge but.

 

And even if you do have a long-dated contract, there will in most cases be some liquidity problems down the track, which means if you sell you might sell at a discount to your expected price, or else wait for liquidity to come into the markets ... which means more time decay.

 

 

 

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We use options exclusively for hedging purposes,

& almost always as the option writer.

 

As a put writer we generally prefer shorter term options at the money, & write with a view to acquiring the underlying. Greeks are important to us, & the premium is the consolation prize if we fail.

 

 

I like this strategy in the current environment. Have been investigating ways to enter an options trade and this is one of them.

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IMO, the expiration risk perceived here is way over-rated with the following.

 

If you own long term, in or at the money calls and the underlying has stayed flat or went down and your thesis is still valid then all you have to do is to reload with new calls at expiration. It is like selling and buying back the stock right away. What is the economic loss other than paying the premium again? At least with the option, you will be allowed to book your loss for tax purposes while with the stock (if it is down) you will have to wait 30 days before buying it back. It could go up in the meantime.

 

It is also wrong to believe that because you have bought a stock and 18 months after it is still flat that you are even. You lost money. There is a cost to dormant capital. There is also a high likelihood that your thesis is wrong. Liquid options are typically available only for decent size companies. This means that these stocks are followed by analysts and others and if they still don't see what you are seeing after 12 to 18 months, then there is a chance that they will never see what you are seeing. That is why I like them for large caps and using them won't force you to go on margin or to displace small caps with more punch in your portfolio if you are fully invested.

 

With options, you know your cost going in: it is the premium paid and the loss of dividends. When you buy the common outright, your cost could end up being 50% or more of invested capital if your thesis turns totally wrong. With margin this has pretty nasty implications. The debt has not gone away and it could result in forced selling if your other positions are also down. People also often ignore the risk of rising interest rate.

 

However like anything else, you have to understand what you hold. If you were thinking to put 10% of your capital into a stock and then you decide instead to put 10% of your capital into at the money calls of the same stock, you don't hold the same kind of weapon. You have to control your greed with options.

 

Out of the money calls and a short duration options are also totally different animals.

 

Cardboard

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IMO, the expiration risk perceived here is way over-rated with the following.

 

If you own long term, in or at the money calls and the underlying has stayed flat or went down and your thesis is still valid then all you have to do is to reload with new calls at expiration. It is like selling and buying back the stock right away. What is the economic loss other than paying the premium again? At least with the option, you will be allowed to book your loss for tax purposes while with the stock (if it is down) you will have to wait 30 days before buying it back. It could go up in the meantime.

 

With options, you know your cost going in: it is the premium paid and the loss of dividends.

Cardboard

 

However the thing with the premium, is that in most cases it is often quite large if you're trying to replicate stock-like returns.

 

Let's take an example;

 

Strike price = $25

Leap/call price = $4

Qty purchase = 100

 

So premium cost = 4 x 100 x 100 = $40,000

If the stock stays flat, and you exercise at $25 near the end of the contract, you lose 40K, assuming the leap expires worthless. In most cases the option price will decay in value due to time, so it might be about $2-$3 by the time you roll it over (or before the expiration date), so that's probably a loss of 10-K-20K.

 

Of course you could gain alot too, but your exercise price has to be above $29 first. So the stock in this case, must increase in value by at least 16% first, or else you'll make a loss.

 

I remember going through this argument/exercise last time on the old Berkshire board, with regards to FFH.

And same thing came up: if you held stock (not the option) for $40K and it stayed flat forever, your only cost is broker commission. If the stock price went up to $29 you'd make 16% i.e. 6.4K, on the option you would only break even.

 

Correct me if I'm wrong here, please. (sorry I'm at work, so I'm in a rush, and haven't thought it through totally and trying to watch over my shoulder if my boss is seeing me type this  ;D)

 

 

 

 

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"I remember going through this argument/exercise last time on the old Berkshire board, with regards to FFH.

And same thing came up: if you held stock (not the option) for $40K and it stayed flat forever, your only cost is broker commission. If the stock price went up to $29 you'd make 16% i.e. 6.4K, on the option you would only break even."

 

This goes to the heart of what I briefly mentioned in my previous post. Investors are complacent with stocks. If they stay flat, they don't care too much.

 

I prefer to see things with a greater sense of urgency. I like Dengyu's term of being "at war". I don't want to take this too far and to expect all my stocks to go up every day, but I would say that if a stock has not moved in my direction within 2 years that there is likely a problem. Some small caps are so unknown that 2 years may not be enough, but a $5 billion or more company? No way!

 

I can't recall too many cases where I made good returns and it did not happen quite quickly. If it is undervalued (50% or more) and attractive others will notice quite quickly enough.

 

It may be another benefit of options with their built-in cost and expiration: they force you to really do your homework on the underlying before entering the trade.

 

Cardboard

 

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