Options: Principles of Usage
First Principles of deploying Options
I have already written a Primer on Options, and a post on Options Pricing. In this post, I am going to talk about the principles behind using options. Instead of focussing on options trading and suggesting boilerplate trades, what I want to do is to go into the intrinsics of when an investor should use them. The rest then flows naturally, or at least that’s how I find useful in thinking. I will do readers a favour and not even discuss greeks1.
There are three principles to keep in mind when thinking about options:
Risk-shifting / Whose risk is it anyway
Aggregated Options Profits & Losses / The House Always Prevails
Cashflow / Cash is king! (More so now than in 2022)
Let’s go through each of them in some details.
Whose risk is it anyway
When thinking of options, I often invoke the analogy of an insurance company. The reason we buy insurance is because we want to shift the risk of some kind of loss (or the downside of an attractive opportunity) from ourselves to the insurance company. On the other hand, the insurance company is happy to take on the risk from you because they think that they are better off collecting a lot of risk from individuals and the collective risk is worth carrying on their books.
Options are pretty much the same. They are a great way to shift the risk of a trade from one party to another. When you buy an option, you are shifting the risk of something happening from yourself to the counter-party. On the other hand, when you sell an option, you are taking the risk upon yourself, with some knowledge that doing so is worth the trade, and that premiums collected are adequately compensating you for carrying that risk.
Every time you underwrite a risk, think about what happens if the next 9/11 happens tomorrow. I dearly hope one doesn’t happen in our living lives, but there is precedent - Stocks as a whole fell 14% within days. Specific sectors fell up to 40%, even without idiosyncratic risk. Where would your options positions be if that were to happen tomorrow? Or today? Or now?
Sometimes you want to take on risk and sometimes you want to pass it on. Think about it carefully.
The House Always Prevails
Like in the Insurance industry, the sum total of options premiums collected by people who sell options regularly in the stock markets is less than what they pay out (in other words, losses they incur). This is the reason some wall street companies (and some individuals) are in the business of selling options - it makes money!
A wilder example of this phenomenon is at the casinos. Even though the outcome of any one event is random and could be wildly loss-making for the house, taken together, across all the bets placed over a reasonable period of time (say a week or even a month), the house always prevails, which is why casinos are such wildly profitable businesses.
Options underwriting can be topsy, turvy, wild ride. You are likely to make large losses from time to time and then in other periods, just collect premiums and bank them in.
If you are in the options selling business, you better do it because (a) it is very situational and you are doing it to take on a specific risk and well compensated for it OR (b) you are doing so regularly enough (and profitably) that you can tide away the choppy losses, and make profits over time. After all, good insurance companies survived and thrived post 9/11.
On the other hand, if you are buying options, you are best placed to do it because you see some idiosyncratic opportunity to move risk away from yourself. If you are going to do it all the time, then it is unlikely that the sum total of all options will profit in the long run. This is why normal portfolios aren’t hedged all the time.
Cash is king! (More so now than in 2022)
One of the greatest upsides of using a good options strategy is that you can manage how you use your cash. Buying a call option instead of buying a stock, allows you to keep the remainder of the investment cash in hand. You could just stash it up in a treasury or gilt and clip coupons while waiting to see if the option has gone up or not. Doing so in 2021 or 2022 was perhaps not that useful, but today the fixed-return assets pay 4%-5% p.a.
Similarly selling a put option instead of buying a stock2 gives you cash upfront that you can stash away and collect interest (and use as a proxy for collecting dividends on the stock, assuming the security paid one).
(ps: Insurance companies that collect premiums first and pay off claims later have structured this cashflow to be hugely beneficial. A great example of this is Berkshire Hathaway which is sitting on billions of dollars of such cash, called “float”.)
Summary
As I have signed off on in my previous two posts (1 & 2), long term investors do not need to use options at all to generate good inflation beating returns. Understanding options allows an investor to occasionally play some situations differently than just buying and holding. Knowing when to do so profitably is a hard skill to master, and I profess no special knowledge in the area, but having a good framework about using options is helpful.
The China trade (references 1 & 2) for the past few months has been the most obvious case where options were a superior form of expressing that trade. I wanted to lay out a small amount of capital to see if I can benefit from a possible rebound in sentiment. If it did, then the benefits would be accretive to the overall investments and if it didn’t, then I walk away having paid the premium, with enough cash still at hand to redo this some other time. I have used a combination of both selling PUTs and buying CALLs. In fact at the time of writing, I have unwound all the PUTs I underwrote (barring one) and am still carrying a series of Calls expressing my bullishness for China.
I find that too many people who enter options think purely along technical terms and are encouraged so by commonly available media. Yet, the real power of options is along philosophical constructs of risk, aggregated-returns and cash flow.
As always Happy Investing!
Options greeks are useful mathematical construct and is worth imbibing into your thinking, but I find them distracting from thinking about options on a first principles basis.
Commonly, trade selling PUTs are set as At the Money, or Out of the Money, and hence the premiums collected are meagre. That works only when you think the asset is overpriced and you are waiting for it to come down, or profit of it never coming down. If the asset is underpriced, a far better trade is to sell Deep In the Money PUTs. i.e if the stock is trading at $10 and you think it will go to $20, then sell the $20 strike Put and wait out to see if the stock goes to $20. If it does, the returns will be as good as you buying it at $10 and the stock went to $20. Obviously you give up on any upside beyond $20.