Most individual investors will be better off if they never touch options. This is not to say that they can’t be good tools, but most people struggle to use them correctly and fail to appreciate the costs involved. Options are not dangerous if you know what you are doing, but can be very dangerous if you do not, or if you get sloppy.
Many years ago, when I first started working, my boss at the time told me a well-worn Wall Street joke:
Question: How do you make a small fortune trading options?
Answer: Start with a large fortune.
In my experience, this is true enough in most cases, but I have seen constructive uses of options as well.
There are a million option strategies, many defensive, many speculative, and many in between. This discussion is not intended to fully cover all the uses of options. Instead, it will be limited to a basic discussion about the two most often used by individual investors: “covered” calls and “insurance” puts.
Before we get into any details, let’s start with two basics of options:
- Always remember that if you buy options it ties up capital and you must consider the opportunity cost.
- Options trade based on the price of the underlying stock or index, not the total return, so you must account for the impact of dividends.
A covered call means owning a stock or index and then selling calls on the same index (giving someone else the right to buy the stock or index at a certain price, usually at the same or a bit higher than the current price).
Covered calls are very popular with some people because at first glance they appear to have an attractive profile. If you own covered calls on a stock or index, you make money if the stock goes up, you make money if the stock stays flat, you make money if the stock goes down a little, and you lose less money than simply holding the stock if it goes down a lot.
It sounds great, but there is a catch. The upside is limited and the downside is not. In fact, owning a covered call is functionally exactly the same as selling a naked put.
In fact, buying a naked put may be better because it only requires one transaction. This is why most commission-based brokers usually recommend covered calls and gave them a more sanguine name than naked puts.
When selling a naked put, you collect the premium, which is the ceiling to your upside. Your downside is unlimited and equals the decline in the underlying position minus the premium for the put. This is the exact same as the covered call.
Does this mean covered calls are bad? Not really. Because the options market is generally efficient, if you constantly buy covered calls (or naked puts) you would end up with an expected long-term total return somewhere close to the return of the underlying, but with lower volatility. You would also pay a lot more transaction costs, and options tend to have larger bid/ask spreads than stocks.
Covered calls can be useful, but they are not a free road to riches. The biggest problem with covered calls is that they generate a false sense of confidence. If a market has low volatility for a while, people can get used to winning most of the time with covered calls. They may then get lured into increasing the size of the bet which can be catastrophic if volatility increases.
There can be times when owning some portion of long stocks and some portion of naked puts can be a good strategy. This would be the case if you believe the expected volatility priced into the market is too high. When volatility is low and options are cheap, covered calls or naked puts are rarely worth it. But volatility is nearly as hard to predict as the market and most people are not equipped to try.
Bottom Line: Most people should avoid using covered calls or naked puts. They can be acceptable at times and can reduce volatility if used correctly, but they do not eliminate risk and probably reduce the expected return of a portfolio over time when compared to simply owning stocks long.
Using Puts as Insurance
Buying puts as insurance is similar to using covered calls except it places a floor on losses while allowing for significant upside. Using puts as insurance implies you only buy an amount to protect an equal or lesser amount of the security in question than you already own.
Effectively buying puts for insurance on a position you already own is actually the same thing as simply buying naked calls.
Again, “using puts for insurance” sounds a lot better than “naked calls”, and results in an extra transaction on both sides, so it is more popular in the broker community.
Like covered calls, there is nothing inherently wrong with using puts. Most approaches will reduce volatility and therefore reduce expected long term return. This may be an acceptable trade-off for some people.
Unlike covered calls, this is a better strategy when volatility is cheaply priced. In normal times, it may cost something like 10 percent to insure against losses in the S&P 500 for one year using at the money puts. This number changes a lot. You can also buy out of the money puts which are cheaper but allow for greater losses. Don’t forget that you will tie up capital by buying puts. This is important and is a problem.
The nice thing about using puts or buying naked calls is that you know your downside. There can be situations when this is valuable.
Bottom Line: Usually, people want to buy puts at exactly the wrong time. When the market is going down and the price of volatility is spiking is not the time to buy puts. Just remember that you are really buying naked calls and it will help you resist this temptation. Simply reducing equity exposure when the market is dropping is often a bad idea, but it is usually a better value proposition than buying market insurance with puts when they are expensive.
Sometimes, puts can provide worthwhile insurance.