The financial industry is nothing if not inventive. Salesmen are constantly trying to push complex products onto an unsuspecting public. The more fancy sounding the product, the more money that the brokers and fund managers make. Today OfWealth takes a look at one of the current fashions, and why it’s best avoided. As always, simplicity rules.
“Eat what you kill.” This charmless phrase is the one used to describe how retail stockbrokers (sorry….“financial advisors”, or “wealth managers”), get paid more according to how much they sell to their customers – especially in the USA. There’s a direct, formulaic link between fees and commissions earned and bonuses pocketed.
In other words there is a huge incentive to sell fancy sounding products with high fees and commissions attached. Customers are encouraged to churn positions – buying and selling regularly. And bells and whistles are added to give a veneer of sophistication, and a justification for higher charges.
Ten or so years ago the buzz was around “structured products”. These would package together financial derivatives into something that sounded attractive, but ultimately would tend to give a poor result to investors.
Typically these products are made up using complex financial derivatives such as call options. A call option is the right, but not the obligation, to buy something in the future at a price agreed today. Let me explain that in clearer language.
Imagine a stock has a price of $20 today. Instead of buying the stock I buy a call option for, say, $1. That option has a “strike” or exercise price of $21 and lasts for three months. In other words, it gives me the right to buy the shares for $21 over the course of the next three months.
Obviously I wouldn’t exercise that right today, since I can buy the shares more cheaply in the market at $20. But let’s say the stock price then increases to $23. I can use my call option to buy it for $21, sell the shares for $23 and make a two dollar profit on the $1 spent to buy the call option (less dealing costs).
In this example the share went up 15% ($3 on $20) but the profit on the option was 200% ($2 on $1). On the other hand, if the stock price didn’t rise above $21 – the strike price of the option – then the call option would expire worthless and incur a 100% loss on the $1 invested.
In other words options used in this way, on their own, are highly leveraged and risky. On the other hand, structured products that include options aren’t necessarily risky, although they can be. But they do tend to have poor returns, or unnecessary – and sometimes impenetrable – complexity, or both.
So much for structured products, which tend to involve buying options of one kind or another, buried within a package of promises. More recently the trend has been to encourage unsuspecting investors to sell options to other people (which really means to trading desks at investment banks – guess who gets the better deal…).
The idea is that by selling options the investor can make extra income in a low yield world. That sounds like a pretty attractive prospect. But as usual it’s not as clear cut as it looks at first glance.
There are two main strategies that tend to get the hard sell treatment these days. These are selling “put options” and selling “covered call options”.
A put option is similar to a call option, except it gives its owner the right to sell at a fixed price, instead of the right to buy. So if I sell you a put option on a stock, and the stock price falls below the option strike price, you have the right to sell me the stock at that price.
When you exercise that right, I have to stump up the cash to buy the shares. In other words, if the market crashes I will get a huge cash call. I may be forced to sell other investments, at precisely the wrong time, to raise cash to honour the option contract.
Also I will probably end up buying the stock for substantially more than the market price at that point, since I’ve locked the purchase price into the option that I sold.
This kind of strategy to sell put options is best avoided. Not least because stock markets have a regular habit of falling hard – roughly once every six years in the case of the US. The last big fall started in mid-2007, over eight years ago. In other words, expensive US stocks are living on borrowed time (see here for more).
The other major option strategy that gets touted is selling “covered calls”, which I’ll explain in more detail. The means you only sell call options on stocks that you already own. In other words you are “covered” if the option owner exercises their right to buy the shares from you, which you are forced to sell at that point. This is less risky than selling puts, but still ultimately flawed.
Let’s say you own a share that’s priced at $100 that pays a dividend of $2, which is 2% dividend yield. You sell a three month call option for $1 with a strike price of $55. Over the course of the year – assuming the price doesn’t rise above $55 – you sell four options, bringing in $4 of extra income, taking your total income yield to $6, or 6%.
So far so good. But you’re giving up potential capital gains in return for income. If the share price rises to $60, the owner of the call will buy it from you for $55, and you lose $5 of capital gains that would otherwise have been yours.
Maybe that doesn’t strike you as much of a problem, particularly if you think the market is going to go sideways because it’s trading at an expensive level. But because you still own the shares you’re still exposed to market falls in any case, even if the extra income provides a bit of a cushion.
Here at OfWealth, we’d say it’s much better simply to look for better priced opportunities around the world, and hold for the medium to long term. And don’t forget that in most countries income is taxed at higher rates than capital gains, which further erodes the supposed benefits of selling covered calls.
But even assuming that this kind of strategy might work, it’s still plagued by problems. One is pricing the options. How do you know that you’re getting a good deal? Option pricing is actually a highly complex business, involving very fancy financial formulae. But even putting that issue aside, the chief problem with selling covered calls is the sheer amount of work involved.
Let’s say you own shares in 30 companies, which is about what you need to be sufficiently diversified. You sell three month call options on all of them. Each time the options expire – assuming they expire worthless to their owners – you sell new three month call options.
That means that for each share you own you have to do four trades a year. That’s 120 trades a year, or roughly two per week. Plus if the options are exercised you have to sell the shares and find something new to invest in. That could add dozens more trades to the total.
The long term, buy-and-hold, value investor has a much easier life. They have few trades to do and the pleasing knowledge that they aren’t making their broker rich with hyperactive trading.
If, on average, value investments are held for, say, four years you would sell a quarter of the positions each year and replace them with new ones. The result is that, across a portfolio of 30 stocks, an average of seven and a half sales and the same number of purchases, for a total of 15 trades a year. Put another way, that’s a little over one a month.
Which would you rather have to do? 15 trades a year or around 10 times as many?
I certainly know my preference. Keep it simple and keep the hassle to a minimum. There are much better things to do in life than watch financial markets all day long. Most of us already have enough stress and complexity in our lives, without adding to them unnecessarily.
And, if you buy well – namely cheaply – you’ll make just as much money in the long run, and probably more. Leave the expensive fads and fashions to others. Avoid complex option strategies.
Stay tuned OfWealthers,