When people find out you're an options trader, dinner conversations can turn to anecdotes about someone who is making a killing by trading options. Let's follow a recent conversation to determine how we might evaluate such claims.
"My brother has been buying stock and then buying an option to sell it. He makes lots of money."
First, let's look at an example of the trade being discussed. We realize, of course, that he could be talking about a hedged trade in which a put is bought to hedge downside risk. Depending on how many puts he bought and whether or not those puts were at the money, that dinner partner's brother also could have been trading a synthetic long straddle. A regular long straddle is formed when someone buys at-the-money (ATM) calls and puts at the same strike. Further conversation seemed to hint that my dinner partner's brother was likely hedging risk rather than seeking a synthetic straddle, however, so let's go with that supposition.
Many combinations of stock plus puts can be purchased, including one-month puts all the way out to LEAP puts, or in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM) puts. The choice depends on how long the trader wants to hedge the stock and how much of a loss can be tolerated. The stock-plus-put combination shown below hedges the possible loss of the $10,039 (plus commissions) cost of the stock, capping the loss at $654.00 plus commissions for both the stock and put purchase.
100 Shares of Apple Stock and 1 JAN15 100 Put:
I told that dinner partner who was considering utilizing the same strategy that this was a well-recognized conservative strategy. It utilizes options for their original purpose: to hedge against a too-large loss. Like all options strategies, however, I cautioned that it has pluses and minuses.
The pluses? If the chosen stock happened to be one that produced a dividend, the trader would be able to capture those dividends, so that might be one advantage to holding a stock plus put strategy rather than a pure long straddle. The strategy is a simple one, not requiring many adjustments. Losses are capped, and yet the trader can participate in gains in the underlying . . . as long as those gains are big enough or soon enough. A quick gain of $6.00 would have resulted in a theoretical profit of about $378, but if the underlying stock is only $6.00 higher at January's expiration, the trade just breaks even. That's because the put's extrinsic value has been eking away as time passed and expiration approached.
The minuses? The strategy is expensive. The stock-plus-put purchase requires a substantial investment.
Also, if the underlying takes off to the upside, gains are steady but the trade would obviously underperform a straight purchase of the stock. If the trader wanted to maintain the protection, by January or perhaps earlier, the expiring JAN15 put would need to be replaced. Decisions would need to be made about when to roll that put.
For several years, we have been in an environment in which many stocks have been climbing relentlessly. Implied volatilities for many underlyings' options have been low, making such options relatively cheap by historical norms. That is an ideal environment for such a strategy. What if prices are choppier and implied volatilities higher, so that those purchased puts are more expensive?
Options are flexible, however. If prices are choppier and implied volatilities are higher, making options more expensive, traders could offset the cost of the puts by selling a call against the long stock. This creates a combination trade known as a collar: long stock, sold call, and long put.
Example of a SEP14 105 Call Sold against the Stock Plus Put, Offsetting the Cost of the Put:
Although it's not visible on this chart, the maximum loss has now been reduced to $552.00 plus commissions. This is because of the premium taken in on the sold call offsets the cost of the long put.
Because the call was sold about 5 percent above the stock's current price, this strategy still allows the trader to participate in a gain in the stock, but a too-large gain will require either buying back the call at a loss or rolling it out to a higher and/or further-out strike before expiration. Gains are capped, then, by the sold call's strike, and the trader must roll those calls each month, if front-month calls are sold.
However, that need to roll into new sold calls each month can be a plus. Each month, new calls can be sold against the stock, with the premium from the sold calls eventually offsetting most if not all of the cost of the longer-term put. For this reason, some strategists favor selling puts about six months out while selling short-term calls against the stock-plus-put position when constructing collars. Some CBOE-commissioned studies have shown that this type of collar performs well over the long run although it of course underperforms the stock during strong rallies.
Selling calls against the stock-plus-put position is one way that traders can cut down the cost of outlay. Another is to employ a LEAP call instead of long stock when constructing the strategy.
The easy dinner-table conversation did not address another concern when considering new strategies: what about the tax implications? In the wake of the Great Recession, many countries have considered taxing transactions in various ways. I cannot predict which of those rules might be enacted or what new ones concocted. Always consult a tax expert before considering a long-term strategy that involves stock plus options, especially since the repeated buying of puts and selling of calls would result in wash sales. This is true whether the strategy being considered is the stock-plus-put strategy or the collaring one.
What's the point? We all hear a lot of stories about options strategies we might not yet have tried. Some have merit. I've long been an admirer of the collar strategy, for example, or at least in buying protective puts under long-term long positions, but then I've always believed in buying insurance against a loss of my house, car, or health, too. I have done performed long-term back tests of my own of such a strategy.
Options were developed to protect positions against losses. For example, long stock traders needed protection from losses due to sharp declines and those buying commodities from sharp rises in commodity prices.
However, we must pay for the privilege of employing such flexible vehicles as options by educating ourselves in the risks and rewards of such positions. Strategies that are right for one market condition might not be right for all market conditions. Dinner table talk is nice and we might actually discover a trade that appeals, but then educating ourselves must come next.
Now that you've worked through this article, consider running through a synthetic straddle strategy composed of 100 shares of long stock plus 2 contracts of ATM puts. What are the pros and cons?