With market volatility spiking, I thought it would be a great time to describe in detail how our options strategies work.
On the first example on the top of this email, we will outline how selling cash-secured puts work.
If a stock we believe is worth $40 is trading at $32, we might think the reward/risk ratio is better selling puts, especially given that we have been concerned about overall market valuations.
In that example, we sold a $30 put, expiring in 10 months, and we collected $3.00 per share. If the stock expires above $30, you will make a return of $300 per contract, or 11.1% on the maximum risk, 13.5% annualized.
If the stock is below $30 at expiration, you will end up owning 100 shares of the stock at a break-even price of $27. This means that the stock would have to drop by 15.2% before you would lose a penny. That is a very significant amount of protection.
When we get extremely high volatility and stocks are dropping rapidly as they have been over the last week due to fears of Coronavirus, option prices get jacked up. That same stock we sold a put on at $32 might have dropped to $27, and that $3.00 option might now be trading for $7.00 per share, which means it would be showing a $400 mark to market loss per contract. Here is the thing though and this is why we tell investors to focus on where things stand when the majority of our options expire, instead of focusing on the day-to-day or month-to-month fluctuations. If that stock stays at $27, you will be break-even on it, despite the fact that the option currently shows a $700 price, and the stock dropped by 15.2%. We would own the stock, get future dividends,and we would have 50% upside from that price level in our estimation.
When we have gotten exercised on our put options, historically we have generated some of our most robust and dramatic returns in the ensuing years. I have no idea if that will happen this year, as the market could easily recover, but that is how the protection works, and it is why the key is patience and discipline. Time is our friend!
For the second example, we have a covered call. So hypothetically, we have a stock trading at $43, that we believe it to be undervalued. We have sold a $50 call expiring in 10 months, and collected $2.00 per share on that option.
If the stock stays flat, we will have made about 4.6%, plus the dividends during that period. If the stock expires below $50, we will keep the 4.6% and any upside or downside from there, and we will still own the stock.
If the stock expires above $50, we will make 21.7%, or 26.5% annualized, and then we will have sold our stock at $50, settling in cash.
Both of these options strategies enhance income and add a layer of protection to the portfolio. However, you only feel the real impact of it, as we get closer to when the options expire. Going into this recent selloff, we had covered calls on most of our long stock positions. The vast majority of our trading activity over the last 6 months has been selling puts, often quite a bit below the prevailing market prices at the time on stocks we would be happy to own anyways.
I think overall, we are in pretty good shape, and we have a lot of upside from here. There are quite a few great values popping up, so I really wouldn’t mind if we get exercised on our puts, and we will certainly add new positions over time. With that said, the Coronavirus brings a lot of uncertainty and risk as to how it will impact the economy. It will take time to get more clarity and bad news will likely be much more frequent than good news during the short-term.
We need to go into things expecting that and understanding that it is part of the game. If investing was easy, everyone would be rich and there wouldn’t be stress. There easily could be an infected cluster in the United States and if that were to occur, it would probably be pretty ugly out in the markets. However, that shouldn’t change our decision-making or long-term outlook. Of course things can escalate, wars can start, natural disasters will occur, but our job is to make the best decisions with the information that we have. I can tell you that I’m taking steps to add a significant amount of cash to my account over the next month or so, because the type of fear we are likely to see over the next month or so, should bring some amazing opportunities.
Lastly, if you are someone that gets really anxious about the market and investments, my advice to you would be to focus on anything but those things. Anxiety can often lead to emotional responses that are almost always wrong and damaging when it comes to investments. The ability to be patient and let time do its thing, is a big differentiator between those that have long-term investment success, and those that tend to panic.