Investment Strategy

Putting options in their place

Earlier in the week I gave a run down on Argentina. In terms of economic growth potential it provides one of the world’s bright spots. The childish economic policies of the previous government are being replaced by grown-up pragmatism. Today I look at comments from a reader, and in particular the pitfalls of put options.

Argentina now has a great chance to go from bad to less bad, and eventually onto a sound growth footing. But it’s early in the process and 2016 is likely to be a difficult transition year, with high social tensions and still high inflation.

My view is that it’s worth keeping Argentine stocks on your watch list. But, as of now, they are nowhere near cheap enough for the risks involved.

We had plenty of feedback on the article. In particular one member of our OfWealth Thought Club (subscribe for free here if you haven’t already), Rakesh L., made two interesting suggestions that I want to dig into.

Here’s Rakesh:

 

G’day Marco. Interesting commentary.

1) One can make money by shorting the market. Say buy a put on MSCI Argentina index.

 

2) Investing in a hard currency or hard currency area is a cardinal principle.

 

Law and order go hand in hand with hard currency area. Pell-Mell is a hallmark of soft currency area. Whenever I flouted the basic rules, I found myself in the soup.

 

Yours for Health and Wealth

Rakesh

Let’s start with Rakesh’s first point, which is a factually correct statement. But I’d urge caution. Making a bet that markets will fall in the short term – either by short selling or by buying put options – is a risky and complex business.

All option strategies mean you have to be an active investor – constantly checking on market price moves. Here at OfWealth we think you can make good money with a lot less effort, by simply buying things when they’re cheap and holding them for the medium to long term. But it’s worth understanding the alternatives. (See our Wealth Tree: 50 ways to invest article and infographic for the vast array of things on offer.)

There are serious pitfalls to any kind of strategy that uses options. But these are often glossed over by the slick salesmen that promote them. Before I get into that, let’s take a quick look at the other common way to bet on falling markets.

When a trader sells stock short he borrows something he doesn’t own, the stock, then sells it to someone else. If the price falls he can buy the stock again for less money, pay back the stock loan, and pocket a profit (less the cost of the stock loan).

The problem is that if the stock price rises – which it could do indefinitely, and irrationally – he’ll watch his losses mount until eventually he has to close out the trade. He’ll buy the stock for more than he sold it and pocket a big realised loss. Short selling is a specialised area, and best left to the pros.

Another way to bet on a price fall is to buy put options. A put option gives you the right, but not the obligation, to sell a stock (or index) at a fixed price (the “strike” or “exercise” price) within a set period of time – usually a few months or less. I’ll use a simplified example to explain (note: this excludes dealing costs and taxes).

Let’s say a stock trades at $100 and I buy a two month put option with a strike price of $95, which costs me $2.50 (known as the option premium). This put is “out of the money” since the price I can sell the stock at is lower than the current market price.

If the stock price falls to $90 then I’ll make $2.50 profit ($5 difference between market and strike price, less $2.50 paid). That’s 100% on the initial $2.50 outlay. So far so good.

Now let’s say it doesn’t fall that far, but goes to $92.50. That’s my breakeven price, since the strike price is now $2.50 above market, but I paid $2.50 to buy the put in the first place. My profit on the stock fall is cancelled by my cost of the put option, meaning net profit of zero.

If the stock price ends up anywhere between $92.50 and $95 I would lose a portion of what I paid to buy the put. For example, at a market price of $94 I’d gain $1 from the put exercise ($95 less $94). But I paid $2.50 premium to buy the option, so I’d lose $1.50 net – which is 60% of the original money outlay.

If the stock price doesn’t go below $95 then I lose all the put option premium that I paid. It expires worthless and I lose $2.50, or 100% of my stake.

This shows why buying put options is a pretty risky business. If you get it right, or guess it right, you can make a big profit. But you have a short time frame for your bet to pay off, and market timing is an impossible business.

Just because I don’t think Argentine stocks offer good value doesn’t mean I have any idea when or if the prices will fall. It just means that owning them is unlikely to be attractive in the short to medium term due to over valuation. That’s not the same as predicting that a crash is imminent.

But this isn’t the only way to use of put options. There’s another approach which is much less risky: as insurance against market falls, rather than outright bets on that happening.

So let’s say you own lots of US stocks but don’t like to see big swings in the value of your brokerage account when the statements are delivered. You could buy put options to protect you from downside risk in the event of a market crash.

In other words, owning a put option would allow you to sell your stocks with a limited loss of, say, 10% while the market plunges 20%, 30%, 40% or more.

The trouble is that if the market doesn’t crash you’ll be shelling out option premiums – the cost of buying and renewing the put options – every couple of months. In other words it will eat into portfolio returns. You’d probably be better off getting out of US stocks completely and looking for better priced opportunities elsewhere. (For example, Russia.)

Then there’s a third thing you can do with put options. You can sell them to “other people”. This is an investment strategy that’s currently fashionable, especially in the US. It’s usually advertised as a low risk way to earn a high income, often pitched at retirees.

But let me put it this way: if buying put options is buying insurance against sharp market falls, then it’s pretty clear that selling put options is selling crash insurance to someone else.

Big investment banks do this all the time, selling put options to professionally run investment funds. They are experts at managing risk, even if it doesn’t always appear that way. Their big downfall is that they also have a huge amount of leverage, so even a small screw up can sink the bank.

One way they hedge the risk of selling put options is to buy put options elsewhere, including from private investors. If the market crashes they have to buy stocks above market prices from the professionals, but can then sell them to small investors, passing on the loss in the process.

And there’s no prize for guessing who gets the best prices here. The private put option sellers end up selling risky insurance for too little money. The professional money managers buy it at a fair price (if they know what they’re doing). The investment banks pocket the difference.

As you’ll know if you’ve read OfWealth for any amount of time, the US stock market is richly priced and artificially supported (see here for my latest take). That makes the risk of sharp price falls or a crash pretty likely at some point.

…selling put options on US stocks is like selling storm insurance to homeowners in New Orleans, just as Hurricane Katrina approached…

In other words, selling put options on US stocks is like selling storm insurance to homeowners in New Orleans, just as Hurricane Katrina approached the Louisiana coast in late August 2005. You make money at first, when you sell the insurance, but you lose it all later – and possibly more – when disaster strikes the market.

I’m pretty sure that a lot of people that are playing this game – of trying to make income by selling put options, of selling insurance ahead of the storm – will be in for a huge shock one day.

Their extra income looks good now. But they’ll end up having to buy stocks at a high price, as the market starts to crash, and miss the opportunity to buy at much lower prices. They’ll be forced buyers, locked in the burning building, just as most people are scrambling for the exits.

Whatever you do with put options – buying them as straight bets on price falls, buying them as insurance against your portfolio, or selling them for extra income – there are clear risks and costs to be aware of.

You can find more about the complexities and pitfalls of option strategies here and here. In general I’d urge caution before you get involved in any of them. They’re often presented as some kind of income panacea, but the hidden risks and costs are glossed over by salesmen.

And now I’ve written so much about put options that I’ve run out of space to cover Rakesh’s second point – about the importance of strong underlying currencies when it comes to investing in stocks.

The evidence on this is surprising and counterintuitive. More on that next time…

In the meantime let me know if you’ve used or been tempted to use option strategies. If you have used them, let me know how it’s worked out for you so far.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.