Meme Stocks and Options: Introducing Options
A man of my father’s generation once observed that young adults these days have an incredibly wide variety of career options available to them: computer and information technology, education, social services, publishing, film and TV production, travel and tourism, home construction and renovation, agriculture, etc. In my father’s time, it was often the case that you went to work doing the same thing your own dad did. That was true initially of my own dad, who grew up in southern Manitoba. He started by leasing some land to grow wheat. Over time his career shifted, but the options available now make his generation’s choices pale in comparison.
Are we better off, though? Options in life suggest we have freedom and autonomy, but are we really better off for having those choices available to us? The 2004 book, The Paradox of Choice, by Barry Schwartz, suggests we are not.
Nevertheless, it seems inherently superior for the investor to use products that provide choice, or options, when investing. Options are apparently a popular investment tool in the “meme stock” investing world. There will be none of this get rich slowly approach of the patient, well-diversified, long-term investor. No, using options allows one to make a quick profit or get out fast with minimal loss, supposedly.
But what are options?
The Basics of Options
Options are Derivatives
To say that options are derivatives means that options derive their value from some other underlying security. For most of this post I will be talking about options on stocks or Exchange-Traded Funds (ETFs), but you can also trade options on futures or on currency, to name just two different categories.
What is optional about options? Purchasing an option gives the owner “the right but not the obligation” to transact on the underlying security. That right to transact can lead to a purchase or a sale of the underlying security at a particular price which is set in the options contract.
Options can also be sold. In that case, you receive some money for your sale, but instead of a right, you now have an obligation.
This may get a bit confusing, so let’s start with the process that is similar to the buying and selling of any other investment product. When you buy stock, you own a share or shares of the named company. As discussed in my last post on short selling of stock, you are long the shares when you buy. One might say that you have opened an ownership position. When you sell that stock, you no longer own it, and the position is now closed. One option strategy follows that path exactly. First, though we need to understand the two types of options. To illustrate, I will use for the underlying security the SPDR® S&P 500 ETF Trust (SPY), which is one of the most frequently traded securities in the US stock market. As I write this, the market is closed on the weekend of February 27-28, 2021, and SPY’s last traded price was $380.01. Supposing you wanted to use options to take advantage of an expected move in the price of SPY, what might you do?
You could use call options. If you buy a call option, you obtain the right to buy the underlying security at a specified price. SPY has many expiry dates each month, but the traditional expiry date for most options is the third Friday of each month, which for the month of March is on the 19th. On Friday, February 26, call options expiring on March 19 with a $380 exercise (or “strike”) price had a closing bid – ask of $8.36 – $8.42. Let’s imagine that you believe that by March 19, SPY’s price per share will rise to $400. You are therefore speculating on a relatively short-term increase in the price of SPY. You buy one option contract at $8.40.
One thing to note. Although the premium is priced per single share, you must pay that price multiplied by the number of shares in the contract. A standard option contract is for 100 shares. That means, the $8.40 premium will cost you $840 (plus commission, which we will ignore for this post). What do you get for your $840? You get the right to buy 100 shares of SPY at $380 per share, or $38,000. If your guess is correct, and SPY increases to $400 per share you can exercise your $380 contract, turn around and sell your shares for $400 and make $2,000.
In practice, most option traders will “sell to close” the option for the increase in value. That option you bought for $8.40, when SPY was at $380.01, will have at expiry on March 19 an intrinsic value of $20 (market price of $400 – $380 strike price). Perhaps on March 18 or 19 then, you could sell the option for $20 and make a profit of ($20 – $8.40) x 100 = $1,160.
You can see how attractive options can be. Buy 100 shares of SPY directly for $38,000 and selling it for $40,000 means you made $2,000, which is not bad after only three weeks, but a $2,000 profit on a $38,000 investment is only a 5.3% gain. To make $1,160 on an $840 investment is a 138% profit. The leverage is incredible.
What happens, though, if things don’t work out as you had hoped. Instead of rising to $400, the closing price of SPY on March 19 is $379.75. That option expires worthless. Why? Who wants to buy from you the right to pay $380 per share when one can go directly to the stock market and buy it for $379.75? As usual with leverage, the opposite of the potential for a big gain is a big loss, or in this case, a total loss. Your $840 is gone.
One thing you could do in this scenario is “sell to close” your option position early, hoping that you can get some money from the sale to mitigate your loss. Let’s suppose that on March 16, three days before expiry, the trend for SPY was not looking good for you. Maybe SPY was trading at around $383 per share. You might be able to sell the option for $4.00 (or $400 for the contract) to reduce your loss to $440 ($840 cost – $400 proceeds).
The above is a description of a long call, a purchase of a call hoping to profit from an increase in the value of the underlying security, which in this case is SPY. What if you owned 100 shares of SPY but were concerned that SPY might go down in value? You could sell it, but you don’t want to get rid of your position in case it increases in value. Your alternative is to buy a put. For March 19 expiry, the bid-ask for a SPY $380 put is $9.01 – $9.11. Let’s say you bought the put at $9.10.
Purchasing a put gives you the “right but not the obligation,” to sell 100 shares of the underlying security at the “strike” (or exercise) price stipulated in the contract, in this case $380. Let’s imagine that SPY falls to $360 per share and you choose to exercise the option. You can sell your 100 shares of SPY at $380. Now observe that you still had to pay a “premium” of $9.10 per share or $910 for the 100-share contract. This kind of strategy reveals the insurance-like nature of some option strategies. You are protecting yourself against a more major loss. But it’s not total protection. You effectively saved yourself from a $20 per share, or $2,000 in total, decline in the value of SPY ($380 – $360), but it cost you $910 for that insurance premium, so your net savings is still only $1,090.
What would happen to your option if you held it to expiry and your shares of SPY rose very slightly in value to $381 per share. Well, the option you bought would expire worthless, and you would be out the $910 that you had paid.
This introduces two issues. At what point does the long options trader of puts or calls break even, and what about the party that sold the option?
Options Breakeven Point
In the first instance above, when the $380 call was bought for $8.40, the buyer does not break even unless SPY reaches $388.40 by expiry. There are two basic components to options pricing. One is intrinsic value, which in the case of a call, is the amount by which the current market value of the underlying security exceeds the exercise/strike price. This is fairly straightforward. If you have a $380 call and the underlying is at $385, then the option has an intrinsic value of $5.00 ($385 – $380).
The second component is time value, which is dependent on the time to expiry. All things being equal, an option with more time until expiry should be worth more than an option with less time to expiry. In other words, the value of the option erodes as it gets closer to expiry. In the case of a long option holder, if you are waiting for your underlying security to move in the direction you want, you may rapidly find your hopes of a profit being undermined by the approaching expiry date.
Put options reach their breakeven point a bit differently. The strategy with long call options is a speculative expectation of profit. With long puts that are “married” to long stock positions, you want to offset the cost of your insurance premium. So, in the case above, when the put was purchased for $9.10, you want your 100 shares of SPY to reach a price of $389.10 by expiry, or at the time you “sell to close” your position, in order to break even.
What about a long put that is not “married” to an underlying position? In that case, you “bought to open” a speculative position, expecting the underlying security to go down in value. In this way, a long put is like a short stock position. Once again, you take the strike price but this time you subtract the premium: $380 – $9.10 = $370.90. That is your breakeven point.
Just like with calls, puts are also subject to an erosion of value as the time to expiry approaches. It seems like the odds are against the holder of long options. What are the alternatives?
For every buyer of an option, there is a seller. If buying an option grants you a right, selling an option incurs an obligation.
A relatively conservative options strategy, used to generate income, is the covered call. In this case, you sell a call option that is “covered” by your holding of the underlying security. Continuing with our SPY example, let’s suppose that you own 100 shares. You are optimistic in the long run about SPY but in the short run, you think its price will probably be stagnant or might even decrease a bit. To give yourself a bit of room, you sell an “out of the money” call option with $382 strike price, also set to expire on March 19. Since SPY is currently at $380.01, there is no intrinsic value in a $382 option. It is therefore said to be out of the money. Nevertheless, the bid-ask is $7.10 – $7.15. You “sell to open” one contract, representing 100 shares, for $710, which is covered by the 100 shares of SPY that you own. By the time expiry rolls around on March 19, you hope that SPY will have gone up to as high as $382.00, but you don’t want it to go higher. An “at the money” option, that is, when the price of the underlying is at exactly the strike price of the option, is typically not exercised. It only becomes worthwhile to the buyer when it is “in the money.” In this case, that means $382.01 or higher.
If you are lucky, you can keep on selling calls covered by your underlying security and generate an income. However, you can see that there are negative implications, too. What happens if SPY starts increasing dramatically in price? You have capped your profit. In exchange for the premium of $710 you received you gave up any gains beyond $382. You can always “buy to close” the call, but the premium may have increased so much that you may be reluctant to do so. Let’s imagine SPY rose to $400 a week before expiry. That option you sold for $7.10 is probably now worth over $20, and your $710 in income plus the $199 you gained via the price appreciation from $380.01 to $382 is all you get, when you could have gained almost $2,000 if you had just not sold that call.
Short “Naked” Calls
Option traders with well-funded margin accounts and a taste for risk may choose to “sell to open” uncovered or “naked” calls. Naked call strategies differ from the covered calls in that you do not own the underlying security. If you sold a $382 call and pocketed your $710 of premium income, what happens if SPY shoots up in value to $400? You either have to “buy to close” your option for a significant loss before expiry or go to the stock market and buy 100 shares of SPY at $400 per share, which is $40,000. Theoretically, this is the riskiest of option strategies. Since there is no upper limit to how high a security can increase in value, your potential loss is infinite.
Short “Naked” Puts
A slightly less risky but still somewhat speculative approach is to sell to open naked puts. It is less risky in that the maximum loss is not infinite but the difference between the strike price and zero. The bid-ask for a March 19 SPY $378 put is $8.28 – $8.37. If you are able to “sell to open” one put for $830, that’s cash in your pocket. As long as SPY stays at $378.00 or above, that cash stays with you. However, if it drops to $360, you will be obligated to buy those 100 shares at $378 per share or, if you get out before expiry, “buy to close” your put position for an amount much greater than the $830 you received when you opened the position.
A covered put strategy is combined with a short stock position. Imagine selling short SPY for $380. You think it might lose $10 per share so you “sell to open” a put with a $370 strike price. For March 19 expiry the bid-ask is $5.93-$5.99. You sell it for $5.95, bringing in $595. You’ve also brought in $38,000 when you sold short the 100 SPY. Sure enough, SPY drops to $369, your put is “assigned,” and you are obligated to purchase 100 shares of SPY at $370. This assignment closes out your put position and covers your short position in SPY. Net result, you got the premium of $595 from the put and you made $10 per share or $1,000 after covering your short stock position at $370.
However, covered puts are not like covered calls. Theoretically, a short position in SPY could rise to infinity, and your losses therefore could rise way beyond your breakeven point.
Long calls/puts – a position is initiated by a buy to open. It is terminated by a sell to close.
Desired result for long calls – Increase in value of the underlying.
Desired result for long puts – Decrease in value of the underlying.
Desired result for long puts married to a long stock position – Increase in value of the underlying greater than the cost of the option premium.
Short calls/puts – a position is initiated by a sell to open. It is terminated by a buy to close.
Desired result for short calls:
- Covered calls – little to no change in value of the underlying. Premium collected.
- Naked calls – decrease in value of the underlying. Premium collected.
Desired result for short puts:
- Naked puts – increase in value of the underlying. Premium collected.
- Covered puts – decrease in value of the underlying. Premium collected.
The Purposes of Options
Hedge against a loss
This is the case for “married puts,” where puts are bought to protect against a loss in a position you own.
This is also the case for a covered put strategy, as the premium brought in from the sale of the put can mitigate the loss of a short stock position that does not work out.
To a lesser extent, this is also the case for covered calls, where the premium from selling a call can mitigate the loss of a long stock position.
All short options bring in income, but naked calls and puts are more speculative in nature, while covered calls are more income oriented.
Long calls and short puts speculate that the underlying position will go up in value. On balance, the long call is more speculative, while the short put, although risky, seeks income.
Long puts and short calls speculate that the underlying position will go down in value. On balance, the long put is more speculative, while the short call, although risky, seeks income.
Should You Use Options?
If you’ve gone through this much, maybe you are interested in using options. There is a lot to be learned about options strategies and as you can see, there is a lot of risk involved. Over my years in the discount brokerage world, I have spoken to all kinds of people attracted to the allure of big profits from options trading. Unfortunately, I have heard women sobbing between halting words and men despairing over what they can possibly tell their wives. Your option trade, worth thousands of dollars one day, can go to zero overnight. So, if you want to use options, learn as much as you can, develop a strategy, and trade cautiously.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.
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