Before I move on to the promised response to three examples of options usage, duty compels me to point out some general omissions, incompletions, and at least one blatant error in Friday's column.
Let's correct the error first. As if Myron Scholes doesn't have enough problems, somehow in the editing process we changed his name to Byron for Friday's column. Sorry about that, Myron. We'll correct that in the archived version of the report.
As for the other imperfections, the awesome Rule Maker Strategy board members offered some additional thoughts that add a lot of value to Friday's column.
First, "exographer" made an excellent point with regard to my statement that the option price is set by the exchange using a variation of the Black-Scholes formula. The price is of course not set by the exchange, but by the participants.
Also, "gman007" pointed out quite correctly that there is an opportunity to sell the option before the expiration date. As long as the option is not too far out of the money and there is sufficient time until expiry, the investor can usually sell the option and recoup some of the investment. All of my examples assumed an investor holds the option until expiration.
Finally, in my risk profile of the seller of an option, I made the point that the seller has a theoretically unlimited downside risk. As "jibbafool" pointed out, this assumes that the seller doesn't own the underlying stock. Assuming the seller actually owns the stock against which the option is sold (referred to as a "covered" option), the worst that can happen is that the seller must liquidate the stock at the agreed price.
Thanks to all of the Fools on the boards for their contributions.
Let's now move on to an analysis of some scenarios. In his post, fserrano provides examples of three different options strategies. I will quote from fserrano's post:
1) "I could be a VERY CONSERVATIVE investor and still use options as a strategy to accomplish my goals. Example: An investor already own 100 shares of America Online (NYSE: AOL), having bought them on 6/1/98 at $20/share. Today, it trades at $135, but he is nervous about Y2K so he buys a put where he pays $450 and it guarantees a price of $120 for his shares (JAN 120 put at 4.5). For a mere $450 he has bought peace of mind. If AOL tanks, he will sell at $120 and take home a nice profit of $10,000 ((120-20)*100). If Y2K goes smooth, he keeps his shares and takes a $450 loss.... If the market really collapses, AOL is now trading at $60 and things are looking bleak for the whole economy, then the investor can sell his shares at $120 for a $10,000 profit. By the way, this Y2K example is somewhat dramatic but it clearly illustrates the value of hedging with puts."
Before we talk about using options as a way to hedge one's bets, I'd like to reiterate the point that Fools only invest money in the stock market that won't be needed for at least five years. Therefore, we are much less sensitive to short-term changes in price than investors with a shorter investment horizon. Because of our long-term perspective, protection against a short-term downturn in the stock price isn't as valuable to us as it might be to an investor with a shorter time horizon. In the AOL example, fserrano describes an investor using options to hedge a position to protect against a sudden short-term drop in the price. On the surface, it doesn't sound so bad. I mean, only $450 bucks for peace of mind?
I'm not so convinced. The reason the option is so cheap is because at a strike price of $120, the price of AOL stock has to fall all the way from $135 to $115.50 (to include the $450 premium, but not including the commissions) in order for the investor to break even. Looked at another way, our investor is giving up 25% of a year's expected return (assuming an expected annual return of 12%) as insurance against a short-term negative move. In return, the investor receives downside protection that doesn't even kick in unless AOL drops by more than 15% within two months time. Sure, if the price drops to $60 within that time, the investor makes out like a bandit, but that is an extreme example of the ilk often used by the investment shysters to make option investing seem like easy money.
A RULE MAKIN' FOOL doesn't really worry about the short-term direction of stocks. This Fool would rather not give away a large percentage of the expected upside of his investments in return for inefficient protection from the downside. Remember, for investors who intend to be net buyers of stock over the next five or ten years, a drop in stock prices isn't necessarily bad news. Also, the hedging of AOL brings with it a nagging question. If hedging AOL over the Y2K period is a rational decision, what about all the other stocks in the portfolio? If you own 10 tech stocks in your portfolio, you probably have to pay about 4% of the value of your entire portfolio, plus 10 commissions in order to fully insure yourself. I'd rather have the cash to invest at depressed prices if the Y2K results in some garage sale prices on some Rule Maker companies.
2) "I could be an EDUCATED, VALUE ORIENTED investor and still use options as a strategy to accomplish my goals. Example: An investor notices that Waste Management Inc. (NYSE: WMI), a blue chip company, has taken a huge hit on its stock. In the last 3 months, WMI went form $50 to $18. He proceeds to research the company and after evaluating the company's financial data, he believes that the company will be OK in the long term. He could buy shares TODAY at a discount (100 shares at $18), OR he could simply buy a long-term option LEAP for Jan of 2002 at $560. This LEAP contract will grant him, for the next 2 years, the right to purchase 100 shares for $20 each. In this manner he spends $560 instead of $1800, so he has $1300 extra capital to spend. If his research on WMI was correct and 2 years from today WMI is trading higher, he can exercise his option and he can now hold WMI for the long term. If WMI keeps tanking, he will probably loose his $560, but then again he would have lost $1800 anyway if he had purchased the stock."
A LEAP (Long-term Equity AnticiPation security) is an option with a longer time to expiration, which is good. The longer time also increases the cost of the option dramatically, which is bad. In this scenario, Waste Management has dropped 64% in value. Our investor is convinced that this is a great stock to buy. He's got $1800 to buy stock, or he can invest $560 in the option (although I'm surprised that a stock that has just dropped by 64% would feature such a low premium for a two year option). Nevertheless, even though $560 doesn't sound like much, it is 31% of the cost of actually owning the stock outright and not having to worry about where the price is in two years.
Also, in order to make money on the deal, the stock had better be at $23.60 a share in two years time ($18 strike price + ($560 premium / 100) = $23.60 necessary to break even). In other words, even if he was dead right about the stock, and it goes up to $23.60 a share, a 31% increase in two years, he doesn't make a dime. If he had bought the stock at $18, he'd be sitting on a nice gain. The investor not only has to be right, but has to be right BIG in order to justify the upfront costs and the risks that he could lose the entire upfront investment. Let me say that I'd consider a two year LEAP before I would consider a three month option if I was absolutely convinced that the stock would make a big move up. Still, it's all or nothing, which isn't the Rule Maker style.
A RULE MAKIN' FOOL would analyze the company using the Rule Maker criteria (spending perhaps a bit of extra time in light of the recent drop), and simply buy the stock if the company still met her qualitative criteria. She wouldn't be spending the next two years wondering if the price is going to be above $23.60 in two years time, hoping that she doesn't lose her premium money.
Well, I've used up my space for tonight, so I'll continue tomorrow with a response to the third example along with some closing thoughts on options.
Until next time, keep on Foolin'.
What do you think?
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