Investment Strategy

Stock options: Don’t be tempted to sell crash insurance

Options are complex and confusing beasts. Yet they’re often sold to the unwary as if they’re some kind of magic beans. Private investors who are tempted to dip their toe into options are sitting ducks. As such, I believe options should be left to professional traders. A reader’s question is a reminder of the pitfalls of options.

I’ve written about options before, and why I think they fall into the category of things that are “best avoided”. At least by private investors who don’t have an in-depth financial training, and probably also by most of those that do.

If you haven’t read it before, or want a reminder, “Why I never trade stock options” goes into all the complexities of option pricing and such like. I can guarantee that 99.9% (or thereabouts) of people that read it should conclude that they don’t understand options, and that they will never understand them fully. That, in and of itself, should be enough reason to stay away.

This doesn’t mean there isn’t an understandable interest in options. In recent years I’ve seen more and more services that offer “income enhancements” from option strategies. Some pitch themselves along the lines of “This Wall Street secret will make you FREE MONEY in minutes, with just a few clicks of the mouse!”

As I said, magic beans…

Unfortunately, the sales pitches tend to gloss over, or even completely ignore, the risks involved, or the sources of profit that will be foregone in exchange for upfront income.

Anyway, I recently received this message from a reader who is clearly wondering about this stuff.

 

“Dear Rob,

I read your caution on options and have a question. What I was thinking is something like this:

Nobody in this rigged market system we have can buy a stock at the price he/she would like, assuming the he/she is a normal person.

Could it ever be worth “buying a call” to try to buy the company you want at a “good” price, and not have to just watch every day, hurriedly call your broker, go online at your retail account (I do not have one), always watching the market. But this could be nonsensical, since you are adding the cost of the call(s) to your trade cost.

That is as far as I have gotten. I am a retired medical scientist.   

Tom S.”

Just to be clear up front, Tom has got things a little mixed up. But that’s not a criticism in any way, shape or form. Given Tom’s professional background, it’s clear he’s no slouch in the brain department.

But he’s also not a trained finance professional, so there’s no reason he should understand something as complex as stock options. That’s why I think the vast majority of people should steer clear of them.

By the way, I’m not going to run through all the definitions of call and put options, strike prices and other option terminology today. You can find all that in the link above to the earlier article. So if you’re unfamiliar with options then I recommend you read that first.

In any case, let’s unpick Tom’s question. As I understand it he’s asking if there’s a way to use options to automatically buy a stock he wants, but only if the price falls from a currently inflated price to an attractive level.

There is indeed a way, but it doesn’t involve call options. Nor does it involve buying options. Instead it involves put options and selling them to someone else.

The owner of a put option has the right (but not the obligation) to sell something at a fixed price (strike or exercise price) before a certain date (the expiry date). As such, the put option seller is selling that right to them, for a price (the option “premium”).

Owning a put option is a bet that the market price of the underlying instrument – a stock or stock index – will fall. If the market price falls below the strike price then the put owner could buy the stock in the market, and sell it to the put writer at a higher price, making an instant profit.

Alternatively, an investor might own stocks but want to hedge against a sharp fall in the market. Buying an “out of the money” put option, with a strike price below the current market level, will limit the downside risk. As long as the put option doesn’t expire, the put option provides the investor with a minimum sale price, being the strike price of the option. As such it places a floor under the investor’s potential losses.

In other words, buying a put option is the same as buying crash insurance. Whereas selling a put option is the same as selling crash insurance.

Going back to Tom’s question, selling put options would achieve his aim of automatically buying a target stock at a lower and “good” price, assuming the price fell below that level. In the meantime, he’d receive cash from the option buyer for selling the right to sell the stock at a fixed level.

Now let’s get into the pitfalls of that strategy, from the put seller’s (Tom’s) perspective.

First, if you’re selling put options then you’d better make sure you have plenty of cash put aside. If the price of the underlying stock falls, and the put owner exercises the option, you’ll have to buy the stock at the strike price.

This is usually glossed over in promotions for put selling services. But if you take into account the large amount of cash that a put seller should have sitting around to cover potential option exercises, the claimed returns on this strategy shrink dramatically.

Second, chances are the stock price will fall below the put option strike price. In other words, at the point when you buy the stock you will be paying above market price. In a full blown market crash scenario, you could be paying way over the odds.

The third pitfall is due to current market conditions. Stocks are expensive. In the case of the S&P 500 they’ve only been more expensive during the heady heights of the technology bubble between 1997 and 2001, and for two months in 1929, just before the Wall Street Crash.

In fact, since 1881, the S&P 500 has only been more expensive less than 3% of the time. And when it was more expensive it was almost all concentrated into that one insane speculative episode that was the tech bubble.

What’s more, the S&P 500 is considerably more expensive now than it was during the last market peak in October 2007, ten years ago. And according to the price-to-sales ratio (P/S), which has a very high inverse correlation to future returns (high P/S indicates low future returns are likely), the market is more expensive now than even during the massive technology bubble of the late 1990s (see here for more).

Do you think this makes the likelihood of a severe market correction or crash more or less likely? I think there’s no doubt that the higher valuations go, the more likely they are to fall. Not only that, but the magnitude of the fall is likely to be larger.

In other words, with the risks higher than normal, anyone selling crash insurance had better make sure they’re charging a lot for it.

Unfortunately, precisely the opposite is happening in the markets.

One of the many factors that goes into the pricing of stock options is the expected volatility of the price of the underlying stock (or index) during the time until the option expires. A higher volatility expectation results in a higher option premium. This is because it means there’s a greater chance of the option price swinging enough to put it in the money at some point before it expires.

This volatility expectation is known as the “implied volatility” embedded in the option price. The market price of an option and the other inputs into the pricing formula – like strike price, the price of the underlying, time to expiry – are known. Using these and some fancy maths the implied volatility expectation can be derived.

In the case of options on the S&P 500 index, this figure is known as the VIX. It’s often referred to as the “fear gauge”. If it’s high, it’s supposed to indicate that traders are nervous. If it’s low, it means traders are calm.

This brings me onto the fourth pitfall of selling put options at the present time. Back in May I noted that VIX had reached record lows, in “Are traders taking record levels of valium?”. As you can see from this chart, nothing has changed and VIX is still ultra low.

The crucial point is that ultra low VIX means ultra low option premiums. Remember: selling a put is selling crash insurance.

So, with stocks riding high and VIX riding low, this means put option sellers are getting paid very little to take on a high risk. I don’t know about you, but that doesn’t sound like a great deal to me.

Selling put options is a way to automatically buy stocks at prices that you deem acceptable, if the market falls. But it’s no free lunch.

Right now, the premium income that you receive for selling the puts to someone else is likely to be inadequate. At the same time, if the market does crash then the price of the stocks is likely to plunge through the strike price. This means that when you do have to buy – as the put owner exercises their right to sell to you – you’ll probably end up paying well above the market price at the time, even if it’s lower than the market price today.

If stock markets crash I’m pretty sure everyone will hear about it, unless they happen to be taking a year out in a buddhist monastery in Bhutan. Every newspaper and TV station loves a good financial drama.

Instead of using options, I recommend just keeping plenty of powder dry in the form of cash (see here for how much). This will allow you to pick up bargains when they become available. It’ll happen one day, perhaps soon.

[For further reading about common stock option strategies see “Complex investment strategies to avoid” and “The devil is in the detail (more on strategies to avoid)”.]

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.

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