options to buy stocks

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engineer1969
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options to buy stocks

Post by engineer1969 » Tue Jul 04, 2017 9:44 am

I have a young colleague at work that is quite enthusiastic about investing. We have frank discussions about risks and strategies for the long haul. He has come up with a strategy into which I can't seem to poke any holes:

If your intent is to buy a stock in the short term, you will always do better by selling an option to buy on the derivatives market at a later date. Typically you are selling this contract to a person who is convinced the value of the stock will decrease. It appears the only scenario where you lose out is in the case that the value of the stock rises above the agreed upon price plus the margin that you sold the contract.

If the stock loses, you still have the contract fee you collected and you own the stock (which you were planning to purchase anyway). His goal is to buy stock.

As an index investor, you'd need a huge volume of cash to employ this strategy, but it seems like a good strategy none the less.

I'm looking for input because I don't trust what appears to be a no-lose approach.

alex_686
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Re: options to buy stocks

Post by alex_686 » Tue Jul 04, 2017 10:03 am

Options are a zero sum game.

Writing Calls, or "going naked", is one of the riskiest strategies out there. I should now, I worked the margin desk during the dot com boom. Loss are theoretically unlimited. Your college is kind of right, if you are only going to own stocks for a short time period the "gearing" (think leverage) offered by options are tempting.

Before you do this, for read "Inventing Money" by Nicholas Dunbar. It covers how Merton and Scholes invested the classic option pricing model, started a hedge fund Long Term Capital Management, and how they made billions. It also covers how they lost over a billion dollars in 6 weeks and needed a bailout organized by the Fed so Wall Street would not collapse. It is a fun read.

There are better books out there but they tend to be very technical and math oriented. Options have a steep learning curve behind them. Hedge funds make huge amounts of money on writing calls, but they have fast computers, fast connections, and hire some of the best rocket scientist around (both figuratively and literally).

Valuethinker
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Re: options to buy stocks

Post by Valuethinker » Tue Jul 04, 2017 10:27 am

alex_686 wrote:Options are a zero sum game.

Writing Calls, or "going naked", is one of the riskiest strategies out there. I should now, I worked the margin desk during the dot com boom. Loss are theoretically unlimited. Your college is kind of right, if you are only going to own stocks for a short time period the "gearing" (think leverage) offered by options are tempting.

Before you do this, for read "Inventing Money" by Nicholas Dunbar. It covers how Merton and Scholes invested the classic option pricing model, started a hedge fund Long Term Capital Management, and how they made billions. It also covers how they lost over a billion dollars in 6 weeks and needed a bailout organized by the Fed so Wall Street would not collapse. It is a fun read.

1 did you not find Roger Lowenstein's "When Genius Failed" to be a far better read?
2 this was the old bond arbitrage team from Salomon. I believe that option strategies were only a small part of the 150 billion of deployed bets the firm made? Also it was clear Merton was marginalized within the decision making by the core ex Salomon team?

Merton and Scholes were brought in later to provide a veneer of intellectual heft to the fund?


The actual collapse of the fund was triggered by a Russian debt default. Again not an equity option strategy.

There are better books out there but they tend to be very technical and math oriented. Options have a steep learning curve behind them. Hedge funds make huge amounts of money on writing calls, but they have fast computers, fast connections, and hire some of the best rocket scientist around (both figuratively and literally).
I agree entirely w the point about writing naked calls and risk.

Just don't. Best advice anyone can give.
Last edited by Valuethinker on Tue Jul 04, 2017 10:48 am, edited 1 time in total.

msk
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Re: options to buy stocks

Post by msk » Tue Jul 04, 2017 10:32 am

Your colleague is right, and you do not need a huge amount of cash. I have used this technique on numerous occasions. This is what I often did with SPY:

1. I have $100k that I want to place in SPY and my nose tells me that SPY is going sideways for many months to come. SPY is currently at 242, i.e. I want to purchase about 200 shares (you have to round up the numbers to multiples of 100 for Options contracts). So I Sell 2 Put Contracts on SPY at a strike price of 242 maturing one year hence and collect $2600. If SPY drops below 242 in one year's time, I keep it at a $13 discount per share. And repeat. If it goes up, I have pocketed $13 + whatever meagre interest my $100k has earned over the year.

2. I have $100k but I feel that the current market is over-valued. I buy 200 SPY and Sell 2 Call Contracts at a Strike price of 242 maturing one year hence. Collect $2600. After one year if SPY has gone up I still have $2600 + the dividends on SPY but I forego anything from the SPY price rise. If SPY goes down I have lost no more than anyone else, but I did get the $2600 free bonus.

Anyway, that's the rough scenario. To make money you need to have a nose that smells the stock market trends reasonably well. In practice I did NOT sell the Puts or Calls at the current price of SPY but slightly higher or lower depending on my sense of smell. Why did I stop? Got fed up of watching the market daily. Overall you cannot, of course consistently beat the market returns since your nose is no better than most other people's, but it can work, quite often. Just remember: To sell Puts you must be ready to buy the stock. To sell Covered Calls you must be ready to sell the stock. Start small, very small, till you get the hang as to how these things work. PS. Options are not the BH way of relaxed investing.

Valuethinker
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Re: options to buy stocks

Post by Valuethinker » Tue Jul 04, 2017 10:33 am

engineer1969 wrote:I have a young colleague at work that is quite enthusiastic about investing. We have frank discussions about risks and strategies for the long haul. He has come up with a strategy into which I can't seem to poke any holes:

If your intent is to buy a stock in the short term, you will always do better by selling an option to buy on the derivatives market at a later date. Typically you are selling this contract to a person who is convinced the value of the stock will decrease. It appears the only scenario where you lose out is in the case that the value of the stock rises above the agreed upon price plus the margin that you sold the contract.

If the stock loses, you still have the contract fee you collected and you own the stock (which you were planning to purchase anyway). His goal is to buy stock.

As an index investor, you'd need a huge volume of cash to employ this strategy, but it seems like a good strategy none the less.

I'm looking for input because I don't trust what appears to be a no-lose approach.
If you wrote naked calls on Apple Google Amazon etc you got destroyed.

If you wrote naked calls on s and p 500 you took some real pain over majority of sub periods.

Btw Andrew Lo one of the best finance professors wrote a fun piece "Capital Decimation Partners" about a hedge fund that does just this. Makes a nice living for its managers 9 years out of 10, producing modest returns for its investors. Every so often it blows up completely wiping out the capital of investors.

Valuethinker
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Re: options to buy stocks

Post by Valuethinker » Tue Jul 04, 2017 10:34 am

engineer1969 wrote:I have a young colleague at work that is quite enthusiastic about investing. We have frank discussions about risks and strategies for the long haul. He has come up with a strategy into which I can't seem to poke any holes:

If your intent is to buy a stock in the short term, you will always do better by selling an option to buy on the derivatives market at a later date. Typically you are selling this contract to a person who is convinced the value of the stock will decrease. It appears the only scenario where you lose out is in the case that the value of the stock rises above the agreed upon price plus the margin that you sold the contract.

If the stock loses, you still have the contract fee you collected and you own the stock (which you were planning to purchase anyway). His goal is to buy stock.

As an index investor, you'd need a huge volume of cash to employ this strategy, but it seems like a good strategy none the less.

I'm looking for input because I don't trust what appears to be a no-lose approach.
Note also you lose the dividend income which is a significant proportion of long run returns.

Topic Author
engineer1969
Posts: 103
Joined: Tue Jul 05, 2011 6:56 pm

Re: options to buy stocks

Post by engineer1969 » Tue Jul 04, 2017 10:35 am

Valuethinker wrote:
alex_686 wrote:Options are a zero sum game.




I agree entirely w the point about writing naked calls and risk.

Just don't. Best advice anyone can give.
Can you guys elaborate on the risks? He isn't buying on margin as he is totally intending on buying the stock and has the funds. It appears like he is accepting money to wait and buy it at a later date. He is doing his diligence and researching the companies he is purchasing.

As an index investor I have no experience to refute his claims at this point. It just looks too good to be true.

Valuethinker
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Re: options to buy stocks

Post by Valuethinker » Tue Jul 04, 2017 10:42 am

msk wrote:Your colleague is right, and you do not need a huge amount of cash. I have used this technique on numerous occasions. This is what I often did with SPY:

1. I have $100k that I want to place in SPY and my nose tells me that SPY is going sideways for many months to come.
Mate if you can predict markets like that then you could easily be a hedge fund manager and make millions or 10s of millions a year.

I'd quit boasting about it on the internet's and, like Dr Michael Bury, hurry up and do it.

At the very least I'd start posting my calls, so that I could use that documented track record on my fund raise.

Otherwise you'd fall into the category of "a guy in the pub told me he makes millions spread betting" type conversation?
SPY is currently at 242, i.e. I want to purchase 200 shares (you have to round up the numbers to multiples of 100 for Options contracts). So I Sell 2 Put Contracts on SPY at a strike price of 242 maturing one year hence and collect $2600. If SPY drops below 242 in one year's time, I keep it at a $13 discount per share. And repeat. If it goes up, I have pocketed $13 + whatever meagre interest my $100k has earned over the year.

2. I have $100k but I feel that the current market is over-valued. I buy 200 SPY and Sell 2 Call Contracts at a Strike price of 242 maturing one year hence. Collect $2600. After one year if SPY has gone up I still have $2600 + the dividends on S
Anyway, that's the rough scenario. To make money you need to have a nose that smells the stock market trends reasonably well. In practice I did NOT sell the Puts or Calls at the current price of SPY but slightly higher or lower depending on my sense of smell. Why did I stop? Got fed up of watching the market daily. Overall you cannot, of course consistently beat the market returns since your nose is no better than most other people's, but it can work, quite often. Just remember: To sell Puts you must be ready to buy the stock. To sell Covered Calls you must be ready to sell the stock. Start small, very small, till you get the hang as to how these things work. PS. Options are not the BH way of relaxed investing.

Valuethinker
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Re: options to buy stocks

Post by Valuethinker » Tue Jul 04, 2017 10:44 am

engineer1969 wrote:
Valuethinker wrote:
alex_686 wrote:Options are a zero sum game.




I agree entirely w the point about writing naked calls and risk.

Just don't. Best advice anyone can give.
Can you guys elaborate on the risks? He isn't buying on margin as he is totally intending on buying the stock and has the funds. It appears like he is accepting money to wait and buy it at a later date. He is doing his diligence and researching the companies he is purchasing.

As an index investor I have no experience to refute his claims at this point. It just looks too good to be true.
Something happens, like a takeover bid, causes stock to shoot up 30 per cent. Options are leveraged. He loses a *lot* of money.

Valuethinker
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Re: options to buy stocks

Post by Valuethinker » Tue Jul 04, 2017 10:46 am

alex_686 wrote:Options are a zero sum game.
Because of the bid ask spreads I don't think they are zero sum for retail investors?

They are actually negative expected returns?

Writing Calls, or "going naked", is one of the riskiest strategies out there. I should now, I worked the margin desk during the dot com boom. Loss are theoretically unlimited. Your college is kind of right, if you are only going to own stocks for a short time period the "gearing" (think leverage) offered by options are tempting.

Before you do this, for read "Inventing Money" by Nicholas Dunbar. It covers how Merton and Scholes invested the classic option pricing model, started a hedge fund Long Term Capital Management, and how they made billions. It also covers how they lost over a billion dollars in 6 weeks and needed a bailout organized by the Fed so Wall Street would not collapse. It is a fun read.

There are better books out there but they tend to be very technical and math oriented. Options have a steep learning curve behind them. Hedge funds make huge amounts of money on writing calls, but they have fast computers, fast connections, and hire some of the best rocket scientist around (both figuratively and literally).

msk
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Re: options to buy stocks

Post by msk » Tue Jul 04, 2017 10:57 am

Very low risk provided he does not get too greedy! E.g. I might have told myself last year that I will be content to make 10% p.a. and construct a strategy, but the market has gone up by much more than 10% this past year. So it would have been the wrong strategy, despite having been low risk.

rai
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Re: options to buy stocks

Post by rai » Tue Jul 04, 2017 11:04 am

I sell puts as a means to gain money, not as a substitute for buy and hold which is my major position.

I sell low out of the money puts. Example Amazon was at $800/share and I'd sell a 8 month out of the money put strike $600/share for $8 (iow $800 profit).

Note this is just an example the actual numbers might be somewhat different.

If Amazon does not go below $600 I made $800 for the risk of having to buy the stock at $600/share (or $60K). Theoretical loss of $60K if Amazon goes to zero. However if I was long Amazon at $800 the theoretical loss would be $80K. (note Amazon gives no dividends).

If Amazon were to rise in the meantime say to $1000/share my future put might be worth $1 instead of $8 so I can buy it back and net $700 and repeat the sale for a higher strike price or a longer time out to gain more money.

I'm not saying this is foolproof but it's not horrible. In my time, out of lets say 1000 trades. Maybe 50 trades have been in the money and executed or had to be bought back, If they execute you need either the money to buy the shares or take a margin loan. Then you have the shares at a discount price or at least a discount to what they were selling for.

I just had some shares put to me. I had MO $72.5 put to me when MO was selling at $72

I still made money because I sold the puts for lets say $1/share and the next week MO went up to $74.5 so I was ahead in no time. Plus I sold call at a higher price like MO $75 and picked up another $1/share plus any dividends in the time I own it. If the covered call does not execute I can sell it again all the while picking up the dividends of owning the shares.

--

This is not without risk but I have made money consistently doing these trades.
"Life is what happens to you while you're busy making other plans" - John Lennon. | | "You say that money, isn't everything | But I'd like to see you live without it." - Silverchair

inbox788
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Re: options to buy stocks

Post by inbox788 » Tue Jul 04, 2017 11:14 am

alex_686 wrote:Options are a zero sum game.
Yes! There is no free lunch! Know the tradeoffs when you buy or sell options. Remember, "Look Around the Poker Table; If You Can’t See the Sucker, You’re It"!

Warren Buffet called derivatives financial weapons of mass destruction. He was referring to institutions using more complex derivatives, but options can cause disasters in personal finance.

And upon more detailed inspection, options are a negative sum game when you consider commissions, spreads, taxes and other trading fees.

alex_686
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Re: options to buy stocks

Post by alex_686 » Tue Jul 04, 2017 12:44 pm

Valuethinker wrote:1 did you not find Roger Lowenstein's "When Genius Failed" to be a far better read?
I found it an easier read. I have recommended Lowenstein's book for those more casually interested in the subject. Dunbar book is more technical while still being readable by the layperson. I think Dunbar gives a better explanation of Option Price Theory, which is why I recommend this book to the OP.
Valuethinker wrote:2 this was the old bond arbitrage team from Salomon. I believe that option strategies were only a small part of the 150 billion of deployed bets the firm made? Also it was clear Merton was marginalized within the decision making by the core ex Salomon team?
Yes, lots of different bets. Actually, very few options if I recall correctly. They mainly used other types of derivatives. However they used Option Price Theory to price those derivatives. On Merton, that was not me read of the situation. I got the impression that he was always more interested in the theory rather that the day to day stuff.
Valuethinker wrote:The actual collapse of the fund was triggered by a Russian debt default. Again not an equity option strategy.
Eh. It is like saying that the assassination of Archduke Ferdinand caused WWI. Kind of true, kind of not. The spark that lite the powder keg. LTCM had next to nothing in Russia and other emerging markets. I think around 260k. That lost 980m on their options on the major equity indexes. This lost another 500m on 2 equity trades - Shell / Royal Dutch Oil and VW.

alex_686
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Re: options to buy stocks

Post by alex_686 » Tue Jul 04, 2017 12:56 pm

Valuethinker wrote:
alex_686 wrote:Options are a zero sum game.
Because of the bid ask spreads I don't think they are zero sum for retail investors?

They are actually negative expected returns?
How deep in the weeds do you want to get? There are passive trading strategies that eliminate the bid / ask spreads. I have seen studies which suggest that writing long dated deep out of the money puts generates consistent positive returns thanks the volatility smile.

That being said, the options market is a very efficient market. There are many great option strategies out there but none are easy to implement.

alex_686
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Re: options to buy stocks

Post by alex_686 » Tue Jul 04, 2017 2:00 pm

engineer1969 wrote:Can you guys elaborate on the risks? He isn't buying on margin as he is totally intending on buying the stock and has the funds. It appears like he is accepting money to wait and buy it at a later date. He is doing his diligence and researching the companies he is purchasing.
It might help if you post a specific example. We can work though the option, determine the break even points, and calculate the potential profits and risks.

The risk is simple. Invest in stocks and all you can lose is the money invested. Write naked calls and your losses are theoretically unlimited. So, not just what you invested, not just your investment account, but everything.

Technically you don't use margin to sell calls - after all you are getting the premium. But you do need a margin account because short options have a margin requirement - just like shorting stocks. As the writer the option can be exercised at any time and you are expected to make good on the contract.

Lastly, when you write a short call you are making a bet that the underlying stock price will either be stable or fall. You lose money if the price increases. Do you have enough money to buy the stock today? Good. If the stock price doubles over the weekend do you still have enough money to buy the stock? Triple? Hopefully yes but you will have to.

rai
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Re: options to buy stocks

Post by rai » Tue Jul 04, 2017 2:21 pm

want to check out one or the other books above (inventing money or When genius failed) can't decide which to read.
"Life is what happens to you while you're busy making other plans" - John Lennon. | | "You say that money, isn't everything | But I'd like to see you live without it." - Silverchair

inbox788
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Re: options to buy stocks

Post by inbox788 » Tue Jul 04, 2017 4:36 pm

alex_686 wrote:I have seen studies which suggest that writing long dated deep out of the money puts generates consistent positive returns thanks the volatility smile.

That being said, the options market is a very efficient market. There are many great option strategies out there but none are easy to implement.
That's one of the examples of picking up nickles in front of a steamroller. It might not fully account for disasters like Enron. Plus you tie up a lot of margin, and while your return is positive, does it exceed the risk free interest rate opportunity cost? (especially after fees) And you're not going to get rich with this strategy.

Implementing a strategy is actually fairly simple and you can even automate some of them. The difficulty is that most of these strategies don't really work once you apply them systematically and become ticking time bombs waiting to go off.

http://www.investopedia.com/articles/tr ... ystems.asp
http://www.optionscity.com/algorithmic- ... -software/

ValueInvestor99
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Re: options to buy stocks

Post by ValueInvestor99 » Tue Jul 04, 2017 5:19 pm

[quote]
It might help if you post a specific example. We can work though the option, determine the break even points, and calculate the potential profits and risks. [/quote]

I recently bought HA for 46.95 and sold the July 50 calls for $0.80 per call. So what are my potential
profits and risks?

Topic Author
engineer1969
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Re: options to buy stocks

Post by engineer1969 » Tue Jul 04, 2017 6:17 pm

alex_686 wrote:
engineer1969 wrote:Can you guys elaborate on the risks? He isn't buying on margin as he is totally intending on buying the stock and has the funds. It appears like he is accepting money to wait and buy it at a later date. He is doing his diligence and researching the companies he is purchasing.
It might help if you post a specific example. We can work though the option, determine the break even points, and calculate the potential profits and risks.

The risk is simple. Invest in stocks and all you can lose is the money invested. Write naked calls and your losses are theoretically unlimited. So, not just what you invested, not just your investment account, but everything.

Technically you don't use margin to sell calls - after all you are getting the premium. But you do need a margin account because short options have a margin requirement - just like shorting stocks. As the writer the option can be exercised at any time and you are expected to make good on the contract.

Lastly, when you write a short call you are making a bet that the underlying stock price will either be stable or fall. You lose money if the price increases. Do you have enough money to buy the stock today? Good. If the stock price doubles over the weekend do you still have enough money to buy the stock? Triple? Hopefully yes but you will have to.
First, I want to thank everyone who is contributing here. My gut tells me it is too good to be true, but our worked through examples say otherwise.

This is hypothetical, but assume I've done my research and I am bullish on nVidia and I want to buy some of their stocks.

My choices are: Buy 100 stocks today, Buy 25 stocks Every month or Sell a contract to buy 100 stocks 4 months from now.
You then can look at what happens if it did twice as good as expected, half as good as expected, lost what you expected and went to zero.

These are the hypothetical I laid out for him to explain to me.

Checking the web, nVidia is selling at 139.33 today. If you've done your research, you expect the company to have an expected yield over the next 4 months. Lets call it 4% -- approximately 1% gain per month. Once again -- this is the perceived gain by the investor based on their own research.

option 1, Buy the stock outright today: $13,933 invested.

Twice as good: $15048. You've earned nearly $1115 in 4 months.
As expected: You've earned $557 in 4 months.
Half: You've earned $229 in 4 months.
Lost: You've lost $557
Zero: You've lost $14,000

option 2. This is essentially a periodic investment strategy where the end values trend the same as option 1, but the variance is reduced considerably. (This is how I invest paycheck to paycheck using index funds)

option 3: Sell a contract to buy the stock from another individual 4 months from now at a price of (1.04*139.33 = ~145)

The current contract rate for this agreement is about $13, or $1300 for the contract to purchase 100 stocks.

$1300 is earned up front
Twice as good: This contract becomes worthless to the seller and they opt out. I have the $1300 and the interest I earned on my original 14,000 (liquid) investment
As expected: The contract executes and I purchase the stocks for $14,500. They are worth $14,500 so I net the $1300 gain (>$557)
Half: The contract executes and I purchase the stocks for $14,500. They are worth $14162 so I net $1300-(14500-14162)= $962 gain (>$229)
Lost: Purchase for $14,500. Worth 13376. net $1300-(14500-13376) = +$176 (> -$557)
Zero: Purchase for $14,500. Lost $14500 but gained the $1300 for a net loss of -13,300 (> -14000)

This is all hypothetical based on the nVidia numbers.

Clearly option 2 is the winner in the go to zero case, but I wouldn't call it a good win :)

*Had to correct some numbers from first post

eigenperson
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Re: options to buy stocks

Post by eigenperson » Tue Jul 04, 2017 6:44 pm

engineer1969 wrote:I have a young colleague at work that is quite enthusiastic about investing. We have frank discussions about risks and strategies for the long haul. He has come up with a strategy into which I can't seem to poke any holes:

If your intent is to buy a stock in the short term, you will always do better by selling an option to buy on the derivatives market at a later date. Typically you are selling this contract to a person who is convinced the value of the stock will decrease. It appears the only scenario where you lose out is in the case that the value of the stock rises above the agreed upon price plus the margin that you sold the contract.

If the stock loses, you still have the contract fee you collected and you own the stock (which you were planning to purchase anyway). His goal is to buy stock.

As an index investor, you'd need a huge volume of cash to employ this strategy, but it seems like a good strategy none the less.

I'm looking for input because I don't trust what appears to be a no-lose approach.
This strategy, writing cash-secured puts, is perfectly legitimate. However, it is not a no-lose approach, nor is it "always better" than just buying the stock outright.

It is not a "no-lose" approach, because if the stock goes down significantly, then you lose money.

It is not always better than buying the stock outright, because if the stock goes up significantly, then you do worse than you would have done by buying the stock outright.

In fact, it is in a sense the worst of both worlds; you end up buying the stock if it goes down, and not buying it if it goes up. To compensate you for getting the worst of both worlds, you are paid an option premium, which, at any given time, may or may not be sufficient compensation.

Topic Author
engineer1969
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Re: options to buy stocks

Post by engineer1969 » Tue Jul 04, 2017 6:56 pm

eigenperson wrote:
engineer1969 wrote:I have a young colleague at work that is quite enthusiastic about investing. We have frank discussions about risks and strategies for the long haul. He has come up with a strategy into which I can't seem to poke any holes:

If your intent is to buy a stock in the short term, you will always do better by selling an option to buy on the derivatives market at a later date. Typically you are selling this contract to a person who is convinced the value of the stock will decrease. It appears the only scenario where you lose out is in the case that the value of the stock rises above the agreed upon price plus the margin that you sold the contract.

If the stock loses, you still have the contract fee you collected and you own the stock (which you were planning to purchase anyway). His goal is to buy stock.

As an index investor, you'd need a huge volume of cash to employ this strategy, but it seems like a good strategy none the less.

I'm looking for input because I don't trust what appears to be a no-lose approach.
This strategy, writing cash-secured puts, is perfectly legitimate. However, it is not a no-lose approach, nor is it "always better" than just buying the stock outright.

It is not a "no-lose" approach, because if the stock goes down significantly, then you lose money.

It is not always better than buying the stock outright, because if the stock goes up significantly, then you do worse than you would have done by buying the stock outright.

In fact, it is in a sense the worst of both worlds; you end up buying the stock if it goes down, and not buying it if it goes up. To compensate you for getting the worst of both worlds, you are paid an option premium, which, at any given time, may or may not be sufficient compensation.
It appears when the stock lowers, you always do slightly better than buying outright.
My example above stops at the inflection point. Any gain above twice the expected return would be lost versus buying the stock outright.

This is a stock buying strategy so saying you lose everything is not a fair argument because you would have lost everything had you bought the stock outright. It should work for index funds too.

It appears there are people that are willing to pay you to wait and buy your stock later at an agreed upon price and the time premium paid appears advantageous to someone certain they want to buy stocks.

rai
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Re: options to buy stocks

Post by rai » Tue Jul 04, 2017 7:08 pm

eigenperson wrote: In fact, it is in a sense the worst of both worlds; you end up buying the stock if it goes down, and not buying it if it goes up. To compensate you for getting the worst of both worlds, you are paid an option premium, which, at any given time, may or may not be sufficient compensation.
however, if the stock goes lower you are buying it cheap. Sometimes forced to buy cheap can be the best time to buy the stock. I had some stocks put to me that turned out to be the best time to buy.
"Life is what happens to you while you're busy making other plans" - John Lennon. | | "You say that money, isn't everything | But I'd like to see you live without it." - Silverchair

eigenperson
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Joined: Mon Nov 09, 2015 7:16 pm

Re: options to buy stocks

Post by eigenperson » Tue Jul 04, 2017 7:54 pm

engineer1969 wrote:It appears when the stock lowers, you always do slightly better than buying outright.
My example above stops at the inflection point. Any gain above twice the expected return would be lost versus buying the stock outright.
Yes, I agree. If the stock goes down, or goes up by less than the option premium, you do better than you would have done buying it outright; on the other hand, if it goes up by more than the option premium, you do worse than you would have done buying it outright.

This is not a no-lose strategy.
It appears there are people that are willing to pay you to wait and buy your stock later at an agreed upon price and the time premium paid appears advantageous to someone certain they want to buy stocks.
No, I strongly disagree. If you are certain that you want to buy stocks, this is a terrible way to do it, because you cannot be sure you will get to buy the stock. If the price goes up, you won't end up buying it.

This strategy is suitable for someone who is willing to buy the stock but is also OK with not buying it. It is particularly appropriate for someone who believes the upside of the stock is limited. But it is not a suitable strategy for someone who knows they want the stock for sure. That person should just buy the stock; there is no options strategy that can guarantee to do better.
rai wrote:
eigenperson wrote: In fact, it is in a sense the worst of both worlds; you end up buying the stock if it goes down, and not buying it if it goes up. To compensate you for getting the worst of both worlds, you are paid an option premium, which, at any given time, may or may not be sufficient compensation.
however, if the stock goes lower you are buying it cheap. Sometimes forced to buy cheap can be the best time to buy the stock. I had some stocks put to me that turned out to be the best time to buy.
Unfortunately, with put writing, though you get to buy when the stock is cheap, you don't get to buy it cheaply. You have sold the put, and must buy the stock at the strike price.

For example, suppose a stock is at $100, and you sell a put with a $100 strike price. Then the stock goes down to $50. This may well be an excellent time to buy; however, it is an excellent time to buy because the price is $50. You are paying $100. That makes it considerably less excellent.

If you really want to buy the stock cheaply, you can set the strike price below the current market price, but the options premium will be lower. In the previous example, you could have sold a put with a strike price of $50, when the stock price was $100. Now, if the stock goes down to $50, you actually do get to buy it cheap. But the premium for this contract is likely to be just a few basis points, which is compensation for the chance that it goes even lower than $50 and you have to buy it at $50.

alex_686
Posts: 6149
Joined: Mon Feb 09, 2015 2:39 pm

Re: options to buy stocks

Post by alex_686 » Tue Jul 04, 2017 8:06 pm

ValueInvestor99 wrote:
It might help if you post a specific example. We can work though the option, determine the break even points, and calculate the potential profits and risks.
I recently bought HA for 46.95 and sold the July 50 calls for $0.80 per call. So what are my potential
profits and risks?
The covered call, the safest of all of the option strategies. One of the few that can be executed in a cash account instead of a margin account. Level I CFA question, answers found in the mandatory option booklet that brokers must send out every few years. I am not checking for dividends.

Max Profit $3.85, at any point where HA is trading above $50.

Break Even, profit of $0: When HA is trading at 46.15

Max Loss $46.15, when HA is trading at zero.

2 points can make a line and here are 3. Graph this out, and put a kink in the line at $50.

Topic Author
engineer1969
Posts: 103
Joined: Tue Jul 05, 2011 6:56 pm

Re: options to buy stocks

Post by engineer1969 » Tue Jul 04, 2017 8:15 pm

eigenperson wrote:
engineer1969 wrote:It appears when the stock lowers, you always do slightly better than buying outright.
My example above stops at the inflection point. Any gain above twice the expected return would be lost versus buying the stock outright.
Yes, I agree. If the stock goes down, or goes up by less than the option premium, you do better than you would have done buying it outright; on the other hand, if it goes up by more than the option premium, you do worse than you would have done buying it outright.

This is not a no-lose strategy.
It appears there are people that are willing to pay you to wait and buy your stock later at an agreed upon price and the time premium paid appears advantageous to someone certain they want to buy stocks.
No, I strongly disagree. If you are certain that you want to buy stocks, this is a terrible way to do it, because you cannot be sure you will get to buy the stock. If the price goes up, you won't end up buying it.

This strategy is suitable for someone who is willing to buy the stock but is also OK with not buying it. It is particularly appropriate for someone who believes the upside of the stock is limited. But it is not a suitable strategy for someone who knows they want the stock for sure. That person should just buy the stock; there is no options strategy that can guarantee to do better.
Thank you. I think these are the words I needed to understand the situation better.

alex_686
Posts: 6149
Joined: Mon Feb 09, 2015 2:39 pm

Re: options to buy stocks

Post by alex_686 » Tue Jul 04, 2017 8:44 pm

First, I am not trying to be snide or arrogant. Options are confusing and it can appear that you have gone through the looking glass. Plus I get engrossed in the technical details. And it has been a few years since I have had to do these calculations off the top of my head. Anything in quotes can be found on Wiki.
engineer1969 wrote:Sell a contract to buy the stock from another individual 4 months from now...
This confuses me. What you are describing is a forwards contract, which is a completely different beast. A option contract has to have a option - the buy can either chose to exercise the contract or not. The seller has no option.

For this example I am going to assume we are writing a short put contract for NVDA at $14 premium, a strike price of $140, and a expiration of November.
engineer1969 wrote:If you've done your research, you expect the company to have an expected yield over the next 4 months. Lets call it 4% -- approximately 1% gain per month.
Nope. In option land stocks yield the risk free rate. This is true because of the the "Put–Call Parity". If this where not true we could make free money using the "No Arbitrage Pricing Principle".

I am lazy so I am going to call the 4 month T-Note 0%.

Instead what we look at is the expected dispersion of returns. Yahoo Finance says that NVDA has a implied annual volatility of 45%. We get this from the "Black–Scholes model". So if NVDA is priced at $140, in one year we would expected the standard deviation of the price to be +/- $63. We can annualized that down to 4 months. $140 Strike Price* .45 implied volatility *((4 months to expiration/12 months in a year)^.5), or $36. Lets call it $40 to make the following math easy. FYI, this is a very simplify model, but we need to learn how to walk before we can run.

So we write a put for $14 and wait to November. For simplicity sake

Option #1: Stock Increase to to $180. ($140+$40).
The contract expires worthless. Nobody is going to sell you NVDA for $140 when they can sell it on the open market for $180
You make a profit of $14, the premium from writing the put.
You feel irrational regret for not buying NVDA at a low price when you had the chance.

Option #2: Stock does nothing, trading at $140. ($140+$0).
The contract expires worthless. Nobody is going to sell you NVDA for $140 when they can sell it on the open market for $140
You make a profit of $14, the premium from writing the put.
You feel irrational happy, assigning the profit from your skill as a investor instead of blind luck.

Option #3: Stock does nothing, trading at $100. ($140-$40).
The contract expires in the money. You now must buy NVDA at $140 even though you could go onto the open market and buy it for $100.
You make a loss of $24. ($140-$100+$14).
Not sure how you would feel. Rationally speaking you lost money on the trade. You may feel differently - behavioral economics is funny that way.

Ragnoth
Posts: 231
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Location: New York

Re: options to buy stocks

Post by Ragnoth » Wed Jul 05, 2017 3:20 am

People have really drilled down on the main issues here. The strategy that the OP's friend is employing sounds like selling a cash secured-put (which has a similar payoff structure to selling a covered call).

Without getting too technical, there are two big issues here:

1) You are *forced* to buy the stock at a given price (the "strike" price). This may result in you ultimately paying $100 for a stock worth only $50. Note, you may come out slightly ahead vs simply buying the stock outright due to the option premium... but you would have been better simply sitting in cash.

2) You lose out on any potential gains from the stock's appreciation. If the stock price doubles from $100 to $200, you won't see the benefits. You get the premium from selling the option... but you don't own the stock in the end, and you traded away a 100% gain for a (typically) small 1-2% payment instead. This is the big risk vs. simply holding the underlying stock.

Generally speaking, these two issues are why cash secured puts and covered calls are best used in sideways markets, without big swings one way or the other. You can try to rationalize these issues away by saying "I would have bought it anyway" or "I'm happy with a small gain," but don't fool yourself into thinking that these are goIng to result in magic risk free money.

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