Attentive readers would have noticed that I have used Put Options1 to express bullish trades in the last 2 posts, one on Lenovo and one on Sinopharm.
This Coffee Can Investor blog is about Coffee Can Style of investing, where investors are encouraged, as I do myself, to buy a portfolio of quality companies with a track record of compounding, and then hold them for very very long periods of time. The core premise is based on benefitting from buying small slices of these business on a regular basis and building a collection of stocks, with costs averaged out, and then let the winners work long and hard for us.
Talking about Options in this blog then, is obviously a departure from that norm. I want to use this post to reconcile the gap between the core concept of this blog and the, hopefully occasional, departures into the world of derivatives.
When I am looking at stocks the natural conclusion I arrive it is normally either “Accumulate”, “Maintain” or “Dilute”. However, sometimes, the thinking goes more like “Accumulate if the stock drops 10%”. In such cases, expressing my position by selling a PUT option feels more amenable than just waiting, as you get to either collect the premiums if the event never happens, or acquiring the stock at a lower price (strike price less premiums). However, for me to express these in the form of options, the PUT premiums need to priced attractive enough and that’s precisely what happened in both Lenovo and Sinopharm.
Continued Focus on the Fundamentals
However interesting these options trade might look, my focus is still based on the ground-up research model I follow for the rest of this blog. Trading options solely on metrics like Option Greeks, or Implied Volatility, is not a game I want to enter2. My decision making is based on
an intrinsic understanding of the company and the price of the stock AND
structure of the option should allow me to express my bullish thesis in a risk controlled manner, and yet profit me relative to buying the underlying stock.
For instance, if I didn’t do the ground up work on Lenovo/Sinopharm to have an opinion on whether or not they look like a business whose stock is to be accumulated, I would be in no position to express my additional bullishness through the options trades.
The situations I described in the last 2 posts are also slightly different from each other. Independent of the options trade, I have up-weighted on Sinopharm as there is enough margin of safety already built into the current stock price.
On the other hand, with Lenovo, the options trade was appealing as the margin of safety increased through the process of expressing this trade as an options underwrite. Context definitely matters.
It is also worth noting that options premiums in Hong Kong are priced higher at the moment, and hence expressing these trades as options was lucrative enough for me to enter. I don’t see anything as lucrative in other markets, so repeatability of this kind of trade seems limited.
Upside of Options Trades
Having set all that context, selling the PUT options allows me to
defer buying the stock
at a price cheaper than buying on the spot market OR
profit from the price of the stock not declining to the levels I want (boosting my returns at no outlay of capital)
improve my cash flow
Downsides
But, as we all know, there is no free lunch when it comes to investing. In selling options, I introduce some downsides such as:
giving up on any upside over the premium if the stock rips. I hedge for this by holding enough stock that I would benefit from that happy situation.
introducing margin/leverage complexity into my set up
increase the tax burden (on an options upside), as this tax has to be paid immediately
miss out on any dividends that the company might pay out in the interim
Constraints
In order to enter an options trade, you must use a broker who supports it and have enough trading permissions (which is based on either experience or education) to allow you to place Options orders for it to be feasible at all.
Additionally, contract sizes on Options, 100 in most markets like US, and a variable size in other markets like Hong Kong, force you to take positions in sizeable portions. This is undesirable when you are managing small(er) corpuses.
What if you don’t want to trade options?
I lay out enough reasons for why I think stocks are worth buying (e.g. Brickworks), or not buying (e.g. PetMed Express), as the case might be. Most investors and I will do perfectly fine just ignoring the derivative trades and just buying up the stock, after doing their own due diligence and coming up with their own position sizing. The options upside is likely to be nothing more than infrequent and marginal in any case. Even in my portfolio, the upside through options is likely to be less than 1% of the capital outlay in any given year.
Summary
However, if you are like me, finding yourselves salivating at the idea of acquiring these stocks at a discount to current price OR collecting the premiums and walking away, and if you have the experience and feasibility to trade options, then trades will show up from time to time to deploy your margin upon. I am listing these derivative trades in a separate tab in my Portfolio sheet. At the moment it looks like this:
Please understand the risks carefully before entering any trades, and do your own due diligence before investing - this blog is NOT financial advice.
As always, Happy Investing!
This blog post is not meant to be a primer on Options, though I don’t rule out writing one in the future. For the time being, beginners are best placed starting at the Wiki page and exploring thereof.
That’s not entirely true. I do play with delta arbitrage in options, but that’s distinct from my coffee can portfolio, when I entrust vast majority of my family’s future financial well being. Rest is just for some fun on the side.