Now and then, I get caught up in a conversation about options and why I don’t utilize them in my investment strategies. First off, I love these conversations because they exemplify the greatness of our capitalistic, free-market system that enables everyone to use any number of financial tools to pursue profits.
Second, I don’t utilize options because, by definition, they are short-term trading tools, and I invest for the long term. But, with that said, I am entirely agnostic when it comes to using options as an investment tool. I don’t consider them good or bad. They are simply a tool used by people to achieve a particular financial result. So, for me, this is not a moral question. It’s a question of application.
What’s the Appeal of Options?
The big advantage of buying options is that they enable investors to control a large number of shares with less money than it would cost to own the actual shares. That’s called leverage, which can produce significant results.
If the share price shoots up in a short period of time, the percentage gain in a call option is much larger than if you had bought the shares.
Conversely, if the share price takes a big hit, the percentage gain in a put option is much larger than if you had shorted the shares.
To make significant gains in call or put options, the share price not only has to move sharply in the right direction, but it also has to do so within a short period of time. I don’t know anyone who can do that with any consistency.
In reality, most stocks don’t tend to move up or down sharply in the near term. They tend to move around in a narrow range, sometimes trending gradually higher or lower. When holding stocks, time is your ally. But, when you hold options, time is your enemy because they eventually expire worthless. A part of the price of options is a time premium that diminishes over time. In fact, the vast majority of options expire worthless, which means most investors who buy options lose money.
What About Using Options as Stock Insurance?
One of the more conventional uses of options is as a hedge – like stock insurance. You buy insurance to protect your house or car against damage or loss. You can buy an option – in this case, a put option – to protect against a decline in a stock’s price. You pay a premium for that insurance, and, when you suffer a loss, the insurer makes you whole. In this case, the put option is your insurer.
The payoff from this stock insurance comes when the value of your 100 shares of XYZ Co. falls, and the premium value of your put option increases. But the payoff only comes if you sell the stock for a loss and then sell the premium for a gain – and then the whole transaction is a wash. You could also hold onto your stock and sell your option for a profit. However, if you wait too long, your option could lose time value or expire worthless. Then you have no more protection. You need to buy another put option if you want to hold onto your stock. What’s the point then?
However, if your share price increases above the strike price, your put option’s premium will decline. As the option ages, its premium will decrease even faster. If the share price continues to sit above the put option’s strike price, it’s premium will vanish as its expiration date approaches, when it will expire worthless.
It’s about the same as buying car insurance, which most people renew every six months. We buy the insurance hoping we never have to use it, and it gives us peace of mind, for which we are happy to pay the insurance premium.
You buy a put option hoping you never have to use it, and it provides peace of mind in the event your share price declines. However, if your share price increases, you risk losing the premium you paid for the option. Is that any different than paying a premium for car insurance and then going six months without an accident?
The real question is how one views the value of that protection. Most of us probably couldn’t afford to pay the total cost of replacing a home or a car, making the premium payment a good value – even if you went your whole life not needing to use the coverage.
What’s the Value of Stock Insurance?
Can we say the same thing about the value of stock insurance? First, if you think a stock will go down in value over the next six months, why buy it? And, unless you plan on selling the stock within the next six months, what should it matter what the stock price does? If the idea of a stock declining in value concerns you, you shouldn’t own stocks.
Investors who buy a stock with the intent of selling it within six months or a year are not investors. They are speculators. And maybe they could benefit from stock insurance, with the expectation that their put options would expire worthless if they are successful.
Investors look at stocks with a long-term perspective, having researched the companies thoroughly and selecting those with the best outlook and with an expectation of holding the stock for many years. Under these circumstances, investors don’t need stock insurance.
Like I said at the top, options are neither good nor bad. They are simply tools anyone can use to achieve a particular objective. For long-term investors, they have little utility. For short-term speculators, they can bring a lot of gain or a lot of pain. Pick your poison.
