Options vs. Stock

[ERICOPOLY]

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)

 

Yes, but it depends on when it moves up to the "break even" point.  Let's say that I paid $50 for the Jan 2011 $250 strike FFH call 3 weeks ago, and yes, if the stock is only at $300 in 2011 at expiration then the option holder makes no money.

 

However, yesterday the option holder could have written the 2011 $300 strike call for $50.  In that situation, the gain is 100% in 2011 if the stock is still at $300.  No tax is paid until 2011, and you have a return of capital of $50 which can be reinvested today to boost that return beyond 100%.

 

Anyways, that's if you are concerned about taxation.  I have to keep a lid on my gains this year because I'm doing another Roth IRA conversion.  So I have a different perspective.

 

 

[QLEAP]

Sharp,

 

"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".

 

I wish I had come across this post a year ago :( Better late than never I guess.

 

thanks for the informative post,

Qleap

[scorpioncapital]

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.

 

Why only stocks and options? What about SSF's, single stock futures? In my view, that product is superior to options and ma even be a better way to establish a long position in an equity than buyign the equity on any given date.

[rranjan]

SSF provides the option to build position cheaply but its available for only couple of quarters but again you can roll over to continue having same exposure level. Interesting way to build position but I havn't used it.

[arbitragr]

 

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

 

Okay, so continuing on ... let's say if we wrote a put and the market price is above the strike and the written put enters profitability ... what happens when

1. you exercise early and take the profit and

2. leave it to expire whilst the mkt value of stock is above strike/exercise price?

 

I assume for situation 2 that you earn the premium originally written. But I'd like to know the mechanics of it ... does the put buyer exercise/sell it back or something?

 

Thanks.

[ERICOPOLY]

 

Okay, so continuing on ... let's say if we wrote a put and the market price is above the strike and the written put enters profitability ... what happens when

1. you exercise early and take the profit and

2. leave it to expire whilst the mkt value of stock is above strike/exercise price?

 

I assume for situation 2 that you earn the premium originally written. But I'd like to know the mechanics of it ... does the put buyer exercise/sell it back or something?

 

Thanks.

 

1)

You are saying that you are the writer of the put, so you can't exercise early.  Only the buyer of the put may exercise it.  You may close out the contract at any time to lock in your gains by just buying the put off the market.

2)

You just let it expire.  No action to take on behalf of the writer of the put.  The put buyer only exercises it if the shares are trading below strike, but even then maybe not.  Back in April/May 2009 expirations I had written ORH $40 strike puts.  The shares closed within 8 cents of strike each time (second time the shares closed at $39.99), and some of the shares (but not all) were put to me.  This was annoying because I WANTED to acquire the shares.  Anyway, the person who could have exercised the contracts perhaps did not do so for the simple reason of transaction cost outweighing the potential benefit, or the likelihood that ORH would open higher the following trading day (which happened both times).

[SharperDingaan]

 

Arbitragr: As the put writer of an exchange traded American option, we have no say.

 

The buyer has the ability to ‘put’ the shares onto us at the agreed strike, at anytime up to the expiry date, & could do so whenever the market price fell below the strike price. To exercise, the buyer would simply advise his broker who would advise the exchange; the exchange would then assign the exercise against one/more of the put writers. If the puts are in the money at end of trading on the maturity date, the exchange will automatically assign all the open positions. Until that put matures we have committed $X of T-Bill or borrow capacity, to a potential buy (hence the forest of obligations).

 

To escape early we have to buy the option back, & flatten our open interest. As we will be paying a premium - the time-shift in the greeks is critical to us, as it determines whether or not we will make a profit. For short dated options time is the driver (& the decay is known), for long dated options the driver is volatility (& the decay is unknown).

 

As the short-term put writer the premium income boosts my margin of safety.

As the long-term put-buyer I’m trying to buy when everyone is sure the future is bright (long-term volatility is low), & trying to roll when there is choppy trading (short term volatility is high). Nirvana is a volatility trade that covered the decay cost, leaving me with a zero cost long-term hedge.

 

Greeks are important.

 

SD

 

[EdWatchesBoxing]

Check out the sec filings for the Fairholme fund. You'll see their use of leaps for Sears Holdings over the last few quarters. They must be happy with their calls with the 60 strike price.

 

fairholme sec link

[FlyingArrow]

 

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. 

 

Al, I owe you a beer.

 

Shortly after this discussion I reviewed my leap purchases discussed in a later post of mine in this thread. After selling some FFH common and buying more FFH leaps to increase my exposure I found I had some "spare change" left over. I reviewed GE and pulled the trigger on 45 contracts Jan 11. Paid 2.50 to 2.59 for each. Also bought 500 common.

 

As of today the common is up 18% but the leaps are up 60%. Not bad for 10 days work...

 

Note that I did this following both Al's and my rules. I'd be happy to own the stock at the price quoted on the expiration date (including the call price). If I had just bought the common I would not be nearly as happy.

[Uccmal]

Mark, Save the beer for Sanjeev... For all the beers I owe him for this message board we could keep him drunk for a year. 

 

I actually bought another 20 leaps after I wrote that.  I think GE went down for a couple of days.  I sold some SPY, SBUX, and AXP leaps and bought the GE leaps.  The game is getting a little tougher. 

 

I am thinking we are going to see a 10% or greater correction coming soon to a US market near you. 

 

A.

[StubbleJumper]

I agree on the correction.  IMO, markets have become a little too frothy for my liking.  I've gone from -10% cash to about +10% cash over the past 2 or 3 months.  I am a great deal more comfortable at S&P 900 or S&P 800.  Thankfully, FFH, ORH and BRK already have something of a margin of safety so I do not feel the need to sell them at this point.

 

SJ

[arbitragr]

Okay with respect to selling uncovered calls/puts, what about margin requirements? I'm sure your broker requires you to at least have a cash balance of at least the liquidation value of the option contract (i.e. the amount of shares you're obligated to sell/buy upon exercise)??

 

If you can't use the rest of your cash balance, then you're not really "leveraged" are you? YOu're like an insurance company who has to maintain a reserve.

 

My broker requires me to maintain a margin requirement of = liquidation value of option contract + risk margin (i.e. the potential change in value of option). This is for naked writes only however ... with long calls/puts no margin needed ... obviously.

 

And second question;

 

Why write puts on puts with short term expiration dates? this is the standard convention. Wouldn't it be better to write on long term contracts? That way you 1) get a higher premium for income (usually) ... and 2) get to buy the stock at a lower price in say ... 1-2 years ... which is way better than buying it next month ... assuming the market has moved up substantially in 1-2 years. Berkshire's written put option contracts are very long dated, like 15+ years, the rationale for Berkshire's puts are the same sort of reasoning I'm getting at.

[ERICOPOLY]

Okay with respect to selling uncovered calls/puts, what about margin requirements? I'm sure your broker requires you to at least have a cash balance of at least the liquidation value of the option contract (i.e. the amount of shares you're obligated to sell/buy upon exercise)??

 

If you can't use the rest of your cash balance, then you're not really "leveraged" are you? YOu're like an insurance company who has to maintain a reserve.

 

My broker requires me to maintain a margin requirement of = liquidation value of option contract + risk margin (i.e. the potential change in value of option). This is for naked writes only however ... with long calls/puts no margin needed ... obviously.

 

And second question;

 

Why write puts on puts with short term expiration dates? this is the standard convention. Wouldn't it be better to write on long term contracts? That way you 1) get a higher premium for income (usually) ... and 2) get to buy the stock at a lower price in say ... 1-2 years ... which is way better than buying it next month ... assuming the market has moved up substantially in 1-2 years. Berkshire's written put option contracts are very long dated, like 15+ years, the rationale for Berkshire's puts are the same sort of reasoning I'm getting at.

 

 

Regarding the margin requirements, you do get the put premium upfront and that cash helps you out with the margin borrowing power.  This is most obvious with the deep in the money puts.  Like if the stock is at $29 and you write the $60 strike put for $33.  You can write that put without it impacting your margin buying power at all.  Your margin buying power would be impacted of course if the stock went down, but initially the cash from the put premium is more than 50% of the strike price.  I believe in that example writing the put would actually increase your margin borrowing power.