Stock Options?

[Dr.Crusher]

Hi folks.

So stock options.

Most of the reading material I have seen on stock option has been of the "Get Rich Quick" variety. I believe that I do understand the basics: puts, calls, strike price, American options vs. European options.

I guess I'm looking for some practical information. Right now we have an automatic sell order set up with Ameritrade if stocks (IVV) drops 20%. The problem with this technique is that we risk selling at the bottom.

I think that an alternative would be to buy a put. I've looked at Morningstar but I can't quite figure out how much it would cost (is it per 100 shares?), how to do it and most importantly, how to exercise it.

I'm not interested in going crazy and buying a bunch of derivatives that I don't understand but I would like to watch prices to get a sense of how expensive long-term puts are. Are longer put contracts generally more expensive (per unit time) than shorter contracts or does it vary?

Thanks again!

 

[JPatrick]

Hi folks.

So stock options.

Most of the reading material I have seen on stock option has been of the "Get Rich Quick" variety. I believe that I do understand the basics: puts, calls, strike price, American options vs. European options.

I guess I'm looking for some practical information. Right now we have an automatic sell order set up with Ameritrade if stocks (IVV) drops 20%. The problem with this technique is that we risk selling at the bottom.

I think that an alternative would be to buy a put. I've looked at Morningstar but I can't quite figure out how much it would cost (is it per 100 shares?), how to do it and most importantly, how to exercise it.

I'm not interested in going crazy and buying a bunch of derivatives that I don't understand but I would like to watch prices to get a sense of how expensive long-term puts are. Are longer put contracts generally more expensive (per unit time) than shorter contracts or does it vary?

Thanks again!

A couple of thoughts--and I may not be reading your post entirely right.
First off, if you have a stop loss 20% below the current price of IVV (S&P 500) you do in fact risk a very big loss before you are stopped out. Without looking, I doubt that IVV has even moved 20% over the past year.
Puts are usually priced like calls (commission wise) and they cover 100 shares.
Of course you can sell the put if you like or put the stock to someone if you want..Both through your broker.

 

[growing_older]

Please help me understand this strategy. In case of unexpected volatility in the market you want to insure that any paper losses are converted to actual losses if they are 20% or greater. Why?

 

[kyounge1956]

Hi folks.

So stock options.

Most of the reading material I have seen on stock option has been of the "Get Rich Quick" variety. I believe that I do understand the basics: puts, calls, strike price, American options vs. European options.

I guess I'm looking for some practical information. Right now we have an automatic sell order set up with Ameritrade if stocks (IVV) drops 20%. The problem with this technique is that we risk selling at the bottom.

I think that an alternative would be to buy a put. I've looked at Morningstar but I can't quite figure out how much it would cost (is it per 100 shares?), how to do it and most importantly, how to exercise it.

I'm not interested in going crazy and buying a bunch of derivatives that I don't understand but I would like to watch prices to get a sense of how expensive long-term puts are. Are longer put contracts generally more expensive (per unit time) than shorter contracts or does it vary?

Thanks again!

I had a similar thought while reading the recent Market Timing thread. I've been doing some reading too and have an elementary understanding of the topic, but no experience.

I'm very skeptical about technical analysis in general, but ISTM that the "moving average" filter described there doesn't purport to predict that the market is going to go down, but instead is a signal that the market already is going down. The question is how long will it continue to drop? ISTM that in those circumstances a protective Put might be a good idea: if the market continues to go down, exercise the option (when the moving average gives a "buy" signal?) to recoup equity losses, and if it quickly reverses and moves up again, you didn't sell out of your equities so you profit that way. And possibly buying a Put is not so vulnerable to being "whipsawed" if the market goes up and down like a seesaw. But more information is necessary to know if this is as good an idea as it may appear at first glance.

• Where does the money to buy the options come from? Keeping a cash reserve specifically in order to have money for Put purchases if a "sell" signal occurs would result in lower expected returns for the portfolio as a whole than if that money were invested in other asset classes. Alternatively, one could dispense with the cash reserve and on a signal one could sell only enough to buy the necessary Puts, which leads to the next question...
• How much would it cost to buy enough Puts to hedge one's entire equity allocation? How much cash reserve would be required? Or for the no-reserve option, how much of the equity allocation would have to go? If sale of, say, 5% of the equities would pay for enough Puts to hedge the other 95% in the event of a large drop, that seems worth investigating further.
• What time frame? Buy a LEAPS Put at the first indication of market downturn and hope it doesn't expire before the "buy" signal comes, or buy shorter options and roll them forward if there's no signal by the expiry date? I'd be inclined to the former out of laziness (and concern about transaction costs), but maybe the latter would be a more effective strategy for protecting against drastic market drops.
• Is it legal? There's a poll in the forum somewhere, and IIRC a significant portion of E-R members have all or the great majority of our assets in IRA's, 401(k)plans, etc. Only some option transactions are permitted in these accounts. I think buying protective Puts is OK, but I'm not absolutely certain. For those (myself among them) who fall into that group, that may be ouer answer right there. Maybe I should have asked this question first.

A bit of practice trading with a "dummy" account would probably throw some light on the answers to these questions. Can anyone recommend a good site for options practice trading?

 

[GaryInCO]

You can buy puts for insurance. As the market goes down and your stock loses value, the put gains value. Thus instead of a 20% trialing stop that might bounce you out at the bottom, you have protection that keeps you in your stock position but maintains your account value.

The trouble with buying options (puts or calls) is that they have decreasing time value. That means that farther-out options (e.g. a December put) are more expensive than nearer-in options (e.g. a September put) -- and after you buy them, they decrease in value as time goes on even if the stock doesn't change. So it costs money every day you have this insurance in place.

If you think of it as an insurance premium that you pay without expecting to get it back, that may be OK. But the premiums tend to be expensive enough that you wouldn't want to do this all the time. kyounge1956's idea to buy the insurance only in a higher-risk time -- e.g. when the MA system signals "bear mode" or your 20% stop level is hit -- is a reasonable strategy.

You can get option chain info at lots of places, e.g. iShares S&P 500 Index (ETF) options by expiration - Google Finance. That shows you all the put and call strike prices for one expiration date, and you can look at different expirations to see how they compare.

Each option covers 100 shares. Right now IVV is at about $130 and a September 120 put would cost you about $1.50 per share, or $150 for the 100-share options contract. Then if IVV falls below $120 before 9/17/11, your put will increase in value dollar-for-dollar.

Some background: options have "intrinsic" value and "time" value. The "time" value basically represents the amount of time left in the option, and it decreases steadily as you approach the expiration date. Think of that as your "insurance premium" -- it costs you $X per day to hold that insurance. The "intrinsic" value is the "insurance payoff" value. If the stock goes below the put strike price, the intrinsic value increases. So if the stock went to $115, the intrinsic value of the option would increase by $5, offsetting your stock loss for 100 shares per put. In reality the intrinsic value can have more than that simple value if there is some time left before expiration, based on the probability that it will go below the strike price before expiration. But it's simplest to think of the intrinsic value being (strikeprice - stockprice) or 0, whichever is less. That's the intrinsic value it will have at expiration. (And you must either sell the option before expiration, possibly rolling it into a new farther-out put, or "exercise" it by selling your stock at the strike price.)

Most people who buy options lose money on them. If you're trying to make money by buying options, that's bad. But if your intent is to buy insurance, then you may see that "insurance premium" as an acceptable cost of doing business. Study it carefully to see how much that insurance costs. It ain't cheap. I don't really recommend it unless you really know what you're doing.

growing_older, obviously she's not looking to maximize her losses in case of a bit of volatility. She's looking for protection in a crash. Let's say you bought IVV in 2005. It ran up to a high of about 156.70 in 2007. A 20% trailing stop would have gotten you out at 80%*156.70 = 125.36, in July '08. You then would have avoided the crash down to 69.00 or so in March '09. If you had a similar entry stop to get you back in 20% off the bottom, you would have gotten in again at 120%*69.00 = 82.80 -- so you bought back in over $43 below where you got out, and you're still in today. Doesn't sound so bad, does it?

 

[JPatrick]

growing_older, obviously she's not looking to maximize her losses in case of a bit of volatility. She's looking for protection in a crash. Let's say you bought IVV in 2005. It ran up to a high of about 156.70 in 2007. A 20% trailing stop would have gotten you out at 80%*156.70 = 125.36, in July '08. You then would have avoided the crash down to 69.00 or so in March '09. If you had a similar entry stop to get you back in 20% off the bottom, you would have gotten in again at 120%*69.00 = 82.80 -- so you bought back in over $43 below where you got out, and you're still in today. Doesn't sound so bad, does it?

You have outlined an ideal senario during a market period when most smaller investors had the crap scared out of them (your truly included.) There is a strong possibility this senario would have been much different.
However, given the markets location today, I think the logical defense for the OP is to set a 6-7% stop and throw in a dash of vigilance along with an eye for possible tax loss harvesting.
To be honest, anyone who allows an S&P 500 ETF to slide 20% without intervention is just not involved quite enough.

When the market recovers and we are all high fiving about how great our IVV looks, it may be a fine time to think about the other insurance/income in the form of calls--but not just yet.

 

[GaryInCO]

To be honest, anyone who allows an S&P 500 ETF to slide 20% without intervention is just not involved quite enough.

Hell, I get the impression that most folks around here consider it a sin to EVER sell, unless your AA rebalance requires it or you need it to live on.

 

[DblDoc]

Hell, I get the impression that most folks around here consider it a sin to EVER sell, unless your AA rebalance requires it or you need it to live on.

And they retired early. Oh and some retired into the worst bear since the Great Depression. And they are still retired with portfolios that have recovered. Hmmm. Points to ponder...

DD

 

[GaryInCO]

While that's strictly true, it's a bit of hyperbole, don'tcha think? The Great Depression was a whole 'nother animal. The Dow dropped 90% in the Depression and didn't hit a new high for 25 years. The 2008 bear only knocked off about 55% and recovered most of it within 2 years.

The market also lost 47% in the 70's. It recovered most of it within a year but it didn't hit a new high for 10 years. Of course, we don't know when the market will top its 2007 high, either.

In any event, I didn't say they were wrong. I just meant JPatrick's "not quite involved enough" comment didn't exactly fit in with the general philosophy here.

 

[Nords]

I guess I'm looking for some practical information. Right now we have an automatic sell order set up with Ameritrade if stocks (IVV) drops 20%. The problem with this technique is that we risk selling at the bottom.

Practical: Brewer's recommended McMillan's options book here before, and I learned a lot from it. CBOE also has a number of tutorials on their website (including more McMillan commentary), although they're more interested in turning you into a trader.

The more volatile the market becomes, the more your "risk" of being stopped out approaches "certainty".

Even if there's not a "flash crash", you're still subject to manipulation by market-makers and traders trying to flush out the stops in their program trades.

I think that an alternative would be to buy a put. I've looked at Morningstar but I can't quite figure out how much it would cost (is it per 100 shares?), how to do it and most importantly, how to exercise it.

You'll see prices like "$2.35", which means $2.35 per share. You purchase contracts in increments of 100 shares, so buying one put contract would cost you $235 plus commissions & fees... assuming anyone wants to sell just one.

I'm not interested in going crazy and buying a bunch of derivatives that I don't understand but I would like to watch prices to get a sense of how expensive long-term puts are.

Ah, for "crazy" you'd want to read Dixonge's "Insane ER strategy" thread:
http://www.early-retirement.org/forums/f30/insane-emergency-re-strategy-40682.html

Prices are on a number of brokerage websites, like signing up for options trading at Fidelity. The NASDAQ website will remember your stocks/funds and help you track them daily (or however frequently you check). But I'm always looking for a better site.

Are longer put contracts generally more expensive (per unit time) than shorter contracts or does it vary?

Are you trying to assign rational logic to a trading market?

I'm not sure what objective you're trying to accomplish, other than that you're not trying to turn into a hyperactive trader.

If you're trying to hedge losses, then buying put options will do the job. The problem is that you'll spend hundreds/thousands of dollars per year to reduce the volatility. Even worse, one day you'll decide that you're wasting your money and you won't buy the appropriate contracts-- and the next day the market will drop 15%.

If you're trying to boost returns then there are a number of "exciting" options-trading strategies to attempt to time & predict the market. Refer to Dixonge's thread again.

If you're trying to reduce volatility, then perhaps it's easier/cheaper to pick a less volatile asset allocation. You wouldn't have to buy options and you wouldn't be laying awake at night worrying about the volatility issues.

We find call options useful for rebalancing. When we'd get to the point where we'd need to sell shares, spouse and I would find ourselves letting things run on for a few more dollars of profit. It'd be purely [-]whining[/-] emotional reactions to what should be a logical decision.

I can figure out how many shares I'd need to rebalance if one of our ETFs (or Berkshire Hathaway) rose 10-15% and got outside our asset-allocation bands. Then I sell call options for those shares, usually 6-9 months out, at a strike price at least 10% out of the money. We put the premium in our money-market account and pat ourselves on the back for dealing with the decision. If the shares rise by that amount at expiry then they're called away and we already got a few extra bucks for them. If the shares aren't above the strike and don't get called away... then we already got a few extra bucks for them.

 

[brewer12345]

Crusher, if you are interested in the subject of options, get a decent textbook and start reading. You can also read the OIC stuff and there are OIC-sponsored (online?) classes that seem to be offered to me by Schwab every time I log into my account.

Before you even think about trading options, you should understand and be able to explain in simple English the Black-Scholes model, calls, puts, bull spreads, bear spreads and collars.

I do not habitually buy puts as portfolio insurance, personally. Insurance costs money and over the long term tends to be a drag on performance while not actually providing protection to the long term investor (options don't go out much more than a year). I mostly use options to put on positions on individual stocks. So at the moment I have small positions on individual equities that include long calls on something I like and want leverage to, naked puts written on something that I like and think the options are overpriced on, and a very small synthetic long position (short the puts, long the calls so I gain and lose as the stock rises and falls). But I generally keep my options positions small because options have implicit leverage and you can blow yourself up with them if you are not mindful of how you use them.

 

[ERD50]

I do not habitually buy puts as portfolio insurance, personally. Insurance costs money and over the long term tends to be a drag on performance ...

Agreed. You are essentially buying insurance, and the person selling the ins to you needs to profit long term. So you are spending money (lowering performance) to lower your volatility. Another way to lower your volatility is to just lower your exposure to volatility (use a more conservative AA).

If buying puts was a 'clear win' for the buyer, it would be a 'clear lose' for the seller. No way are the sellers going to take that risk and lose money on average also. IMO, the cheapest way to lower your volatility is to simply reduce your exposure to it. TANSTAAFL.

-ERD50

 

[DoraM]

I am a big fan of trading spreads instead of trading just puts or calls.

This has two advantages:

1) You pay much less time value since the further out of the money option you sell is more time value than intrinsic value versus the in the money option you buy.

2) If it is indeed true that 80% of options expire worthless, it makes sense to buy the 20% that don't and sell the 80% that do. This is somewhat related to 1)

An example on the put side might be buying an S&P500 put at $100 for $10 and selling an S&P500 put at $90 for $5 (I made up these numbers as I am not bothering to get real values, but these could be typical for any index). You then have $5 invested in the spread, but will earn $10 if it drops below $90. You thus double your investment with a 10% drop, where if you only bought the $10 put you would need a 20% drop to double. You don't lose any money with a 5% drop where you lose 50% of your option premium with a 5% drop if you just bought the $100 put.

 

[FIRE'd@51]

IMO, the cheapest way to lower your volatility is to simply reduce your exposure to it. TANSTAAFL.

This is true, but buying a put does this with the added benefit that, because of the way the put's hedge ratio changes with stock price, one gets increased exposure in a rising market and decreased exposure in a falling market. IOW, if one bought an at-the-money put (hedge ratio about 0.5), it would initially cut one's stock exposure to 50%. This exposure would automatically increase or decrease as the stock price increases or decreases. If the put is fairly-priced, the expected return on a stock plus put combination would be higher than the that on a static 50-50 stock-cash mix.

 

[ERD50]

This is true, but buying a put does this with the added benefit that, because of the way the put's hedge ratio changes with stock price, one gets increased exposure in a rising market and decreased exposure in a falling market. IOW, if one bought an at-the-money put (hedge ratio about 0.5), it would initially cut one's stock exposure to 50%. This exposure would automatically increase or decrease as the stock price increases or decreases. If the put is fairly-priced, the expected return on a stock plus put combination would be higher than the that on a static 50-50 stock-cash mix.

I understand the concepts of what you say, but if the bolded part was generally true, why would any mutual fund increase their cash position (beyond what they need for withdraws)? They would buy puts instead?

-ERD50

 

[FIRE'd@51]

I understand the concepts of what you say, but if the bolded part was generally true, why would any mutual fund increase their cash position (beyond what they need for withdraws)? They would buy puts instead?

Assuming the fund can buy puts (and many mutual funds are not allowed to), my guess is that the fund's managers either think the puts are overvalued (high implied volatility) or that they can time the market, effectively creating the put for less.

 

[eatingmywords]

I am a big fan of trading spreads instead of trading just puts or calls.

This has two advantages:

.

To add, consider with a put you're buying unlimited insurance in the even the S&P drops to 0. You probably don't need that much insurance. A spread allows you to tailor the amount of downside protection you really want.

For example, SPY is at 128. The sept 102 put would put you back $300, for unlimited protection. You can offset this cost by selling the 85 put @ $145, for a net cost of $155. Here you're protected as long as the SPY doesn't fall below 85.