In this episode of Industry Focus: Energy, Nick Sciple dives deep into options with Motley Fool analysts Jim Gillies and Jim Mueller. Discover what they are, how you can invest in them, the risks and rewards, time horizons you should target, and a few pitfalls to watch for.
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This video was recorded on July 30, 2020.
Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. Today, we'll be discussing options, what they are, how to use them and mistakes to avoid when you do. My guests are Foolish options gurus, Jim Gillies and Jim Mueller. Welcome to the show, guys.
Jim Mueller: Hey, Nick.
Jim Gillies: Hey, Nick. Hey, Jim.
Sciple: Great to have you guys on the show. I talk to you guys, I guess, around the virtual office these days, around Slack all the time, but hopping on the podcast with you guys is fun. As I mentioned, we're talking about options today. Just first, off the bat, what is an option?
Mueller: So, an option is a derivative security, and what that means is it derives its value from the price of something else, in most cases, shares of some company, and it gives the owner of the option the right to either buy or sell 100 shares per option contract at some agreed upon price, which is called the strike price, on or before some expiration date in the future, which could be anywhere from a week away to a couple of years away.
So, the right to buy is a "call" and the right to sell is the "put," and there are always two sides to this story: There's the buyer, the owner of the option;, and there's the seller of the option. So, there's always two parties to this. And, in order to buy the right, the buyer of the option has to pay the seller a premium, which is the option price, and that premium is the sellers to keep regardless of what happens. And so that's a basic explanation of what options are.
Gillies: Yeah. Just remember, the right to buy, "B" buy is a call, BC. And the right to sell, "S" is a put, PS. So, PS, BC.
Mueller: Yes, I like that.
Gillies: It's probably the first time I've actually said it on air in 10 years. So, you know, nothing like getting to the point, right?
Sciple: So, you talk about an option as a derivative. It derives its price from the underlying security that's related to the option. Why would someone buy an option instead of going and buying that underlying security, that underlying stock?
Gillies: Well, a first reason, what if you're bearish, or what if you think the underlying stock is going to go down? You're actually going to go buy a put option, right, because a put option profits when the stock falls. But assuming you're positive about the stock, why would you buy a call option rather than buying the underlying stock itself? The simple answer is, leverage. If, say, a stock is about $75 and I want to buy an 18-month call option, that strikes, remember as Jim Mueller said, a strike price is what you would buy the stock for. So, let's say the stock is at $75, and you can buy a $75 call that expires in a year and a half, say, you can do that for $11 or $12. So, if the stock, say, goes from $75 to $100 over the next 18 months, the buyer of the stock would go from $75 to $100, they make $25, that's a 33% return. The buyer of the call, who let's say, they bought at $11, I have a very specific stock in mind when I say those, if you bought at $11 and the stock went to $100 that stock or that call rather, would now be worth a $100 minus the strike price, $75, so that would be worth a total of $25. $25 over $11, that's what, nearly a 150% return. So, you buy the stock alone, you make about one-third or 33% return, you buy the call, I just described, you make 150%, ballpark. So, you know, it's pure leverage.
The downside, of course, is, if the stock doesn't go up, if say, it only goes to $80 or $75 or even $70 at expiration, you'll still own the shares at expiration, so you can hope for further gains in the future. The option goes away. And let's say the stock goes to $70. So, you paid $11 for it, and it's striking at $75, the stock goes to $70 expiration, you get a big fat goose egg. So, leverage, potential upsize returns come with elevated risk of losing the capital in play.
Mueller: Right. So, a $75 stock purchase going to $70 is only, what, less than a 10% drop.
Gillies: Yeah, 7% drop or something like that.
Mueller: Something like that. But if the stock is at $70 at expiration, that call is worthless, and so you have a 100% loss. So, you get leverage on the upside, but you also get leverage on the downside, and that's not nearly as nice.
Gillies: Now, you could you also argue, Nick, that well, you know, if the stock isn't $75, and spoiler alert, the stock I'm talking about is Starbucks, because it's a nice easy stock that everybody knows, and it's about $75 today. If you bought Starbucks at $75 today, and you came back a year, a year and a half from now and it's a $70, you wouldn't be terribly upset, right, Starbucks is still, you know -- but if you bought the call options, you could say, well, I only put $11 in as opposed to having $75, so maybe it's not that big a deal. The problem is, if you could buy 100 shares, say, of Starbucks, it will cost you $7,500. So, you've got that $7,500 hanging around, and then, the call option would cost you $1100, because as Jim Mueller said, it's 100 shares per contract. So, it would cost you about $11; it's actually been $11.50, but whatever. So, it would cost you about $1,100 to buy that. You might say, well, you know, since I've got $7,500 here, what I'm going to do, instead of buying 100 shares, I'm going to buy six contracts of the calls. So, I'm going to spend almost my full $7,500, and then, again, if the stock goes up, it's tea and medals all around, we love that; if the stock, say, goes to $70 a year and a half from now, you don't just lose $1,100, you might have purchased more calls that represent more shares than you would have purchased.
So, the key thing for using options Foolishly that we drummed into people for 10, 11 years now is, always know the potential rewards. We're usually really good with knowing our potential rewards. Unfortunately, I have to focus sometimes that we forget our potential risks. So, always understand what's my potential reward and what's my potential risk here.
Mueller: So, I think we've skipped over a couple of concepts along the way. So, a call, remember, is the right to buy shares at an agreed upon price on or before the expiration date. So, that makes money, that becomes more valuable as the share price goes up, because you can buy shares at -- to use the example we're using -- you can buy 100 shares of Starbucks at $75, if the share price is at $90 or $100. Because you can exercise your call, you can exercise that right and force the other person to sell you the shares for $75 apiece. So, you've purchased shares at $75 in the future when the shares are at $100.
The downside to that is, if the shares are at $70 at expiration, and you have not yet exercised that right, that option, then why would you pay $75 to exercise the right when you could go on the market and pay $70 for those same shares? Which is why we say, the option expires worthless, because nobody in their right mind would spend $5 more to buy the shares.
Gillies: Yeah, if you can find that person, you should send them flowers.
Mueller: Yeah, right. [laughs] The other side, the put side is, they make money when the share price goes down, because now you have the right to sell your shares at an agreed upon price. So, again, using Starbucks and that $75 strike, if the shares at expiration are $60, then you can force the other side of the contract, the other person in the contract to buy your shares at $75 when in the market you could only get $60 for them. So, that's why a put becomes more valuable when the share price goes down, because it guarantees you a higher selling price than the current market price. And with the call, it guarantees you a lower buying price than the current price if the shares go up.
The problem is, if the shares don't go the direction you want them to, in the time that you've allotted, OK. So, you have to be right on the direction and on the time. And so, with buying options, that's why we tend to use really long dated, 18-month, 24-month options, to give the share price enough time to move in the direction we want it to and stay there. [laughs] So, we end up with something worthwhile rather than saying, oh, I'm going to do this with a one-month option, because I think Starbucks is going to go shooting up over the next month. And that only gives the shares a month to move. And in the short-term we all know, at least what I hope we all know, that there's no way to predict the movement in such a short-term. You have a much higher chance of being right in your movement direction if you give it a longer-term timeframe.
Sciple: So, fundamentally, the buyer of an option receives leverage by moves in a stock either up or down. The movement of the option will be impacted at a higher magnitude than the underlying stock would be, however, they exchange, forgetting that upside, they exchange a limited timeframe in which for their thesis to take place, and if their thesis doesn't take place then you're going to lose 100% of your investment. Whereas, hey, if I own Starbucks and it falls $5/share, I'm down less than 10%, whereas if I own those options that you talked about earlier, there's 100% capital loss potential for me.
Gillies: Yes, there's a lot -- apologies, Fools, we've been doing this for so long and we've done it so many times that we will probably skip over things. So, I'll throw a plug in here for Motley Fool Options, which Mr. Mueller is the advisor of and which, I guess, I'm the advisor emeritus. I was there for a long time and now I'm up here in Canada most of the time. Your response there was mostly right. But the problem with options, and it is a problem, because what we've talked about with people for years and years and years is, this is a new tool that you're using. When you learn to use options, it's a tool for your portfolio to enhance your returns. And it's a tool that you're going to deploy, ideally, over the next several decades. And you're going to find some strategies that work for you.
But realize that, because it's a new tool, it's a new understanding, it sometimes takes some time to get comfortable with the nomenclature, comfortable with the ideas at play. So, what you were talking with, Nick, you were emphasizing that we're looking at the leverage, which, of course, I kind of started with leverage, so it's probably my fault that you quoted leverage. That's one reason.
But for example, and again, we're using Starbucks as our whipping boy example, whatever, here. So, Starbucks, so it's about $75 today as we're recording. And let's say, you own it but you're a little nervous about a second wave of the virus that's going around or you're concerned that maybe it's going to be a little bit lower in the future. And so, you would maybe buy a put alongside your stock, OK? And remember the put benefits if the underlying stock falls, the put gains value, because again, the put is the right to sell. And you bought the right to sell at $75. What you've done by marrying a long stock or an owned stock with a long put, is you've essentially ensured the price of your stock. You've essentially bought an insurance policy. So, that's not really leverage, right? That's a -- I bought insurance, the same as buying insurance on your house or insurance on your car. I have ensured that no matter what happens for the next 18 months, I protected my value of Starbucks by buying this put. So, if Starbucks, say, goes to $50, just to pick a silly price. Starbucks goes to $50, that would be a one-third loss for the shareholder, but the value of a put option, and a $75 put option today is about $12, just over $12, the value of that put would go to $25. So, the value of the put would go from $12 to $25 at expiration, and you could just sell the put at expiration and you pull in that $25 to offset the $25 drop in stock price.
You're not made whole because of the cost of the put, you did have to buy the put. So, like any insurance policy, insurance costs money. And some people get worried about their stock price and so they buy options. In Motley Fool Options, for years and years and years, we've always emphasized, we are more often sellers or writers of options than we are buyers. Because if you are insuring your stock price, insuring all of your stock prices, I just said that that put for 18 months is about $12 on a $75 stock. That is 16% of the share price. Do you want to pay 16% over a year and a half, let's call that, what, 12% or 11% for a year or 10% for a year? That's expensive insurance. So, we're not really big on buying options for insurance or buying options for anything but, you know, what we think are sure bets for upside, because it is expensive.
Sciple: OK. So, that brings me to the next thing I wanted to talk about. And definitely, folks, it's impossible to cover every possible nuance when it comes to options, so definitely do some side-reading, look into Motley Fool Options, look into the resources that we have at Fool.com and there's great stuff all across the internet. So, if you've done some reading up on options or are comfortable with that area and want to learn more about it, where would you recommend someone starting if they wanted to dip their toe into investing in options?
Mueller: I would probably start with a covered call. It's one of the simpler ones to understand and one of the easiest to set up. And a covered call is you buy 100 shares of some stock. And the idea is to sell one call per 100 shares with a strike just above the current share price, the price you buy it at, and you get paid for that. So, that's income to you. And if the share price moves up to or above the strike price at expiration, then you get that gain up to the strike price. So, again, using our whipping boy, Starbucks, say, it cost you $75 to buy the shares and you sell it in three months. Now we're talking three months because this is a shorter-term strategy that you can do over and over and over again. And note, every time you sell the covered call, you get paid, right. So, that's the appeal to this. Getting paid is good. And so, what's -- I don't have my chain-up, so what's a $80 call going for in ...
Gillies: ... an $80 call. So, Starbucks stock price, as we speak, is just over $75, so let's call it $75. At an $80 call, you would get about $3.15 in October.
Gillies: Yeah. So, that gives you $3.15 with the promise to sell your shares at $80, because the owner of the call is not you, so the owner of the call would pay you $80 in three months, and say, the shares go up to $79 by expiration. Well, the owner of the call is not going to exercise it because he can buy shares cheaper on the market, as I said earlier. And so, then now you've got $3.15, and you can sell an $85 call expiring in January. And say, the shares go up to $82 by January. And so, now you've got another $3, so now you've made $6, $6.5. And now you do it again, selling in April [laughs] we do this in three-month steps, and sometimes I just have to work it through my head. In April. And you do it for the $85s again, because the share price is down at $82, $81, but this time the share price goes up to $90. So, you've now made another $3.25. We're up to $9.75 ... so, we're up to $10 in income over nine months. And we bought it at $75 and now we're going to sell it at $85. So, we've made another $10 from the sale price, because those shares, you let them be called away or you let them be sold.
So, you've made $20 over nine months, which is, in real money terms, because we're talking per share prices, a single contract is 100 shares, so that's $2,000. So, you made $2,000 when the share price went up only $15, you made $20 when the share price only went up $15. So, you can boost your portfolio returns by doing that kind of thing over and over and over again. And you can just do that as an income strategy with covered calls and generate a nice stream of extra cash income into your portfolio. And this can be done inside IRA and other tax advantaged accounts or it can be done in a taxable account or in both places. And so that's a very nice strategy.
There's a couple of things to be aware of, though. This is an income strategy, income. Those premiums are being paid for selling those calls. Do not worry about what's happening with the share price. You want those premiums, because that's your income, and you get a bonus by selling your shares at a higher price sometime down the road. That's your return. If Starbucks goes to $250.
Mueller: Yeah, Coffee-as-a-Service, that would be an amazing story [laughs] dominating the financial news headlines. But you have that $85 call that you sold. Shares are way, way above the strike price, but all you get is the strike price, you do not get any of the money above $85. So, remember that. You are selling away all the upside above the strike price in return for that premium. But if you can do this over and over and over and over again then it's a nice stream of income. So, don't do this on those highflyers please, because they will move massively high and you don't get any of it.
Gillies: And you will lose it. Yeah, no, Jim has said here. I think it's really important, Nick, what Jim just said there about, by selling a covered call, by engaging in covered calls, you are selling the upside. So, you are implicitly saying, when you sell the upside in return for a premium, even though it's only three months, you know, we talked about Starbucks, it's at $75, we're selling the upside above $80, if we're doing a three-month $80 covered call, you are implicitly saying by selling the upside above $80, I don't think there is any upside above $80, much beyond the $3 call premium we would get. And it is the time value of money argument you can pull in there as well. But for all intents and purposes, you are saying, I do not believe there is upside beyond the strike price, or if you prefer, beyond the strike price plus the premium. So, when you engage in this, there's no moaning after the fact if, again, Starbucks becomes Coffee-as-a-Service and goes to $200. Because you entered a strategy where you are willing to take a cash premium today in return for the perceived upside.
The other thing I wanted to emphasize, to lever off of what Jim said there is, yes, you can do this and should do this in tax sheltered accounts where possible. If you do it in a taxable account, and you do it with shares that you have long owned. So, let's say you have Starbucks going back to the early 2000s, or even 2008, and Fools, you could buy Starbucks in the chief of the credit crisis, you bought Starbucks for $4/share, dead serious. So, now it's $75, you've got a near 20-bagger in Starbucks. That's a heck of a capital gain. And if you start doing covered calls on shares you have owned for a long time and where you have a large unpaid, unrealized capital gain, the day your shares are taken from you, you have just triggered yourself a nice, large tax bill, if it's in a taxable account. Don't do this. When you are going to do covered calls, we have always advocated the concept of the buy right.
So, most people have different types of accounts, they have a tax-sheltered account, they have a taxable account, whatever. Wherever possible buy new shares for your covered calls, even if you already own shares -- especially, if you own shares in another account with high unrealized capital gain. Buy new shares and work your covered call magic on those new shares, don't give yourself a tax bill, because, we promise, we 100% promise, I mean, I'm so confident of this, I'm willing to speak for Jim over here as well. We promise, at some point, you're going to lose shares you don't want to lose.
Mueller: Yep. So, we call this rule No. 1. If you do not want to sell your shares, do not write that covered call. So, again, always do this with brand-new shares. If you only have the one account and you've got some long-held shares, buy new shares. And then when that ...
Gillies: ... or pick another target for covered calls.
Mueller: Or pick another target. But most brokers will now allow you to specify which shares are sold when the covered call is exercised, if you do it within a certain amount of time. So, talk to your broker before you do that to make sure you understand how to set that up, because you don't want to trigger that tax bill [...].
Sciple: So, we talk about covered calls, I can hear a lot of beginner investors saying, hey, I have to go buy a 100 shares of a stock to even set up this strategy. What would you say to someone like that, that says, hey, I don't have enough cash to run this type of covered call strategy?
Gillies: Well, I mean, you don't have to do it on Starbucks. I mean, there are stock prices in the $20s, and $30s and teens and even single-digits you can do it with. The important thing is, make sure it's a company you know and understand. So, regardless of the share price. Like, you know, doing this on Amazon and its $3,000 share price, probably out of the range for most retail investors, I'm confident in saying it's beyond my range. So, I'm just not going to do it, and plus, I don't want to sell the upside of Amazon. But you can pick some -- there's a perfectly acceptable target at much lower share prices. And so, one covered call of a $20 stock, it would cost you $2,000 for the shares, you're probably going to get back $1.50 and $2 for the call options, so you're going to get back $150, $200 there. And then if selling, you know, a strike price that's near, let's say, $20, $25 stock price or $22.50, probably, strike price, you know, it's not that expensive, really. And if even that is too expensive for you, then Fools, trust me, options aren't for you yet, but the options markets, they will be there for you when you build your portfolio to a size where you can do that. But, you know, just take your time and learn all you can.
It's funny, I mean, we could literally talk about covered calls only for a long time. The so-called Bible of options investing, folks, is by Lawrence McMillan, it's called Options as a Strategic Investment. And it weighs about 78 pounds, it's about 13 ...
Mueller: [laughs] He's only exaggerating a little bit.
Gillies: It's a heavy book, it's a big book. And it's about, I think it's 1,400 or 1,500 pages. I believe I don't have my copy down off the shelf at the moment, but I believe there's something like eight, 10 chapters on covered calls. It is easily the strategy, and there are all kinds of different strategies, folks, but it is the strategy that McMillan spends the most time drilling it into your head to understand, because it is very much a bread-and-butter. And one last point in covered calls, because I don't think we mentioned it earlier, and it ties back to what I said earlier about, always knowing the risk and reward. So, Jim has done a very good job of explaining the reward and the repeated nature of covered calls.
The risk of covered calls, what's important about it, is that it is really, really, really hard to blow up your portfolio using covered calls. So, sometimes people will say, option strategies are risky. It is almost nigh impossible to do serious damage to your portfolio with covered calls, because you're not actually taking on the leverages some other strategies do, you're just running an income strategy. So, for newcomers to options, it is comparatively safe. And a lot of times you'll hear, oh, options are so risky, they're so scary, but of course, also, options are where you can make these multi-bagger gains in short order. The scary stuff and the risk of catastrophic losses is the price you have to pay to get the potential multi-baggers, whereas a covered call is a very simple, it's an entry-level strategy, very, very low risk. Literally, it's actually lower risk than buying a stock.
Let's say catastrophically, a $20 stock, you have to pay $2,000 for a contract, to buy 100 shares, right. A covered call on it, let's say, pays you back $2. You're paying net $18 to buy the stock for $20, you get back $2 from selling the call. Then, let's say, the company is complete and utter fraud goes to $0 before expiration. The guy who bought the shares -- and that doesn't happen, Fools, but I'm just being silly.
Mueller: [laughs] I'm assuming it's Luckin' Coffee.
Gillies: Yeah. Well, but even Luckin' Coffee is not a $0, right. I mean, even it's not a $0. The guy who bought the stock alone is out $2,000. The guy who put the covered call is out $1,800, because, yeah, the stock is worthless, but so is the call that you sold. So, you know, it's actually a way of reducing your risk in a position. So, a covered call, if you heard nothing else, this is where you want to start, Fools.
Mueller: And while I get that it's boring, I get that it's slow, but it is a much surer route to getting options working well for you and really helping your portfolio over time than spending money to buy a two-week call that you hope this price will go up high enough, fast enough for you to make your money when the odds are that you will lose your money instead.
Gillies: Yeah, at 100% of the money. The people who like to speculate on one or two month or less than one month, buying out of the money calls, out of the money means, the strike price is above the stock price. So, if the stock price -- so, Starbucks again, we'll go back to Starbucks; this is a good example. Starbucks is at $75 today, if you are going to buy, say, well, we're recording this mid-week, you can buy Starbucks options expiring in two days, an $80 call, say -- a pretty bad example -- let's say next month. An $80 call next month. You say, I think Starbucks can still go up, you're going to spend about $1.60 to buy a one-month call option on Starbucks.
Now, that's not much money, right, it's going to cost you $160 for a month. And if Starbucks is over $80, let's say it goes to $85, you're going to triple your money. Well, the likelihood is Starbucks is not going to go to $85 in a month, it's not. I mean, it would be nice if it does, I own shares, I would be happy --
Mueller: And you're not going to be satisfied with only a few hundred dollars, you're going to buy 10 of these contracts.
Gillies: Yeah, exactly, or more. So, the likelihood is you're going to torch your money because the stock will not go above the strike price. And these options -- time erosion in the last month of an option's life can be pretty brutal, that time erosion refers, Nick, to how fast the premium goes away if the stock is below the strike price ...
Mueller: For the call ...
Gillies: Yeah. So, you're going to see that money go away fairly quickly. So, baby-steps, be boring. Trust us Fools, it is a better way.
Mueller: It is more exciting than just buying Starbucks and putting them in the wall safe for a while.
Gillies: Oh, sure, yeah.
Mueller: Yeah. Because you're doing something every three months, right, so.
Sciple: So, it sounds like, when you talked about the covered call, the fact that your downside is limited, some of the mistakes that new investors make thinking about all these leverage returns that you can get that it sounds like, for a beginning option investor what's really important is to not get your eyes focused on, look how much money I can make if the things work out, but to really understand what is my risk if my thesis doesn't play out, particularly in the context of what you said earlier, that the vast majority of options that are bought end up expiring worthless.
Gillies: Yeah, always understand your risk, the reward will take care of itself, but understand your risk.
Mueller: Yeah, the fewer unforced errors you make, the better off you'll be, so. But we can talk about one more strategy that does give you a bit more leverage, but requires a bit more time in return. And that's called a bull call spread. And this cost less money than a covered call, but it takes 18- to 24 months to work out. So, the idea here is, again, Starbucks. So, do those strike on $5 or $2.50 increments?
Gillies: They strike on $2.50, so the stock is at $75, so let's do $72.50 and $77.50, what do you think?
Mueller: OK. So, a bull call spread is ideally set up using the furthest out in time options you can find. Find that option, then stop looking. As Jim told me once years ago.
Gillies: Yeah, I was going to say, like a decade ago, when we were having this chat, it's like, yeah, go out as far as you can, stop.
Mueller: And if all you can go out is six months or nine months, don't even bother. Again, because you want to give the share price enough time to move in the direction you want it to move. So, it is buying a call that is striking just below the share price. So, the $72.50, January 2022. And it is selling a call just above the share price, so the $77.50 in January 2022, expiration. And ideally it will cost you right around half that strike price difference. So, $77.50 minus $72.50 is $5. And so, you want to aim to pay right around half that. So, $2.50. So, what's the price?
Gillies: OK. So, the January 2022, $72.50 call option on Starbucks, you're going to pay $12.75 for that. So, Fools, if you've got your pen and paper down. So, you're going to pay $12.75 to buy the $72.50 January 2022 call. Then you're going to sell or sell to open the January 2022, $77.50 call, you're going to get paid about $10.40.
Mueller: Pretty close. [laughs]
Gillies: So, net-net -- yeah, it's almost like, we've done this once or twice, Jim. Net-net you are going to pay about $2.35 for this particular spread.
Mueller: OK. So, $77.50 is above $75 is $2.50 out of $75 which is ...
Gillies: It's about 3%, call it a 3% gain.
Mueller: Call it 3%. OK. So, if, at expiration, in January 2022, about a year and a half from now, if at expiration, the share price is anywhere from $0.01 to $1,000 above that $77.50 strike price, that spread is going to be worth $5, OK, no more, because that short call is working against you, pressing against you. So, all the big gain in the long call is offset by a lot of gain in the short call, the sold one. So, $5. So, you would close that by buying to close to $77.50 and selling to close to $72.50 in January 2022, and you would close that for as close to $5 as you can manage, probably around $4.90, $4.95. So, you're doubling your money in 18 months.
Gillies: Yeah, you're doubling your money, effectively, off of a 3% upwards stock price move, there is your leverage, Nick.
Mueller: That's the sweet parts. Well, a 3% stock move gives you 100%, or in this case, a better than 100% return in 18 months, and that is fantastically sweet.
Gillies: Yeah. Now, I do have one caveat to that, because I always have a caveat.
Sciple: And what's the risk, Jim?
Mueller: Ah! There you go.
Gillies: Well, OK, there you go. Thank you, Nick. Thank you. The risk is, if the stock is below both strike prices at expiration. So, if it's below $72.50, as Jim just said, whether it's $0.01 below, so it finishes at $72.49 or whether it's, say, Starbucks is a fraud, goes to $0 -- Starbucks isn't a fraud, but you know what I mean. It doesn't matter where it is below $72.50, below $72.50, both options expire worthless, you lose 100% of the money you invest in here. So, that's your risk.
Mueller: In this case $2.35 per contract pair.
Gillies: Right. So, this is, all options are risk/reward, risk/reward. So, your risk is, you will lose 100% of the money you invest here. The reward, or the potential reward, is you will double -- or as Jim says, slightly more than double what you put in. And off a 3% move.
There's one other little risk to be aware of here, and I apologize in advance, this is slightly esoteric, but it is something to be aware of. And Jim knows where I'm going, I think. Starbucks is a dividend payer. So, Starbucks pays a $0.41 dividend every quarter. They also have a history of raising it. So, there's a good bet that by the time 18 months pass and we come up on the January 2022 expiration of these, I'm willing to bet the dividend will probably be higher. And so, the problem here is when the stock price is above the upper strike price, the option that you sold, the call option that you sold, so above $77.50, you run the risk of that option will be assigned early, so whoever buys it from you will exercise it early into steal a dividend away.
And now, there's kind of a weird formula. And the problem is, what will end up happening, the mechanics of this. If that were to happen to you, you would end up being short the shares on the ex-dividend date, because when a call is assigned against you, they pay you the money, the strike price, but then you're short the shares as they close that out later, so. But you, if you are short shares on the ex-dividend date, you, Nick Sciple, have to pay the dividend. So, you don't really want that to happen. And, look, there is what, six, seven dividends between now -- or five or six dividends between now and the expiration of these. You're probably good for the first three or four, unless Starbucks runs up to $150, don't worry about it, because there's something called time value in an options price that there will be sufficient time value, that's what the market ascribes to the option for the chance of being in the money at expiration, you're probably fine for the first three or four, but as you come up to, say, the dividend payment right before expiration or the one closest to expiration or maybe the two, the stock runs away on you. Those are where you want to be aware. And so, maybe you close your spread a little bit before the stock has run up and you've got most of your value, rather than me going through the esoteric calculation here ...
Mueller: So, talk to your broker. At least two brokers I know of, Interactive Brokers and TD Ameritrade, I know, give you a warning ahead of time, ahead of the dividend, ex-div date of the dividend saying, your option is at risk of being assigned early, because technically the remaining time value is less than the dividend. And we're not going to go into what time value is here, or how to find out, you can find that on the interwebs quite easily.
And so, the person who owns that call is going to exercise it early because they get a bigger economic benefit by capturing that dividend rather than keeping the remaining time value. But the situation is, the share price has to be above the strike price of the sold call, from your point-of-view of the sold call, and the dividend has to be large enough to make that action against you worthwhile. It's solvable, you can get out of it, you can recover from it fairly easily, but it's a bit of a hassle, and you don't want to be on the hook for that $0.41 or $0.46 dividend that Starbucks is paying.
So, there is that one wrinkle. So, if you do a bull call spread on a stock that doesn't pay a dividend, then you're home free. I mean, at least you don't have to worry about that.
Gillies: Or a stock that cooperates for, you know, a buy. Because again, bull call spreads, you don't want to, hey, we're doing this via Zoom, so you don't really want to do a bull call spread, says, on a fast-grower, really volatile stock like Zoom, you don't, because who knows where it's going to be.
Mueller: Yeah, and if it goes up a lot, then all you've got is that $5 or $10 spread, and the shares are up to $100, so.
Gillies: Exactly. Now, the good news is, that Zoom doesn't pay a dividend, so you wouldn't have to worry about what we just talked about, but you know, for a bull call spread, you kind of want a nice, big quality company that's kind of boring, frankly. You know, that's not going to -- you're not really expecting fantastic upside from, and you're not really expecting big, risky downside. Because, I mean, look, if I told you guys a year from now, you can't look at the market between now and one year from today, and I told you Zoom will be either 50% higher or 50% lower. Could you favor one of those two outcomes? I don't think you could. I think you could probably say, yeah, I could see Zoom, or pick any of the other recent highflyers that were considerably lower, say, in March of this year, when the market got freaked out about the virus, the pandemic. But, you know, if I came back to you and said, hey, a year from now what do you think is more likely, Starbucks will be up 50% or down 50%? I think you'd probably both be picking door No. 3, and go, I think it's going to be within the boundary. Like, most likely it'll probably be plus or minus 15%, 20%.
And so, those are the kind of companies you want for a bull call spread. Again, option ...
Mueller: And for a covered call.
Gillies: And for covered calls. Exactly. And options are -- I know they get a lot of press in, like, Robinhood right now and it's very --
Gillies: [laughs] Exactly. It's very trendy and people are getting -- Fools, options done Foolishly should be calming and boring. There's lots of excitement out there in life you don't need -- because, again, everyone loves upside volatility, we all love upside volatility, downside volatility is not so pleasant, especially when you are playing with various forms of leverage.
Sciple: Yeah. I mean, so it sounds like, when you mentioned that the bull call spread, it's almost kind of a way to inject some extra risk into some of these more boring stocks, inject some little more upside into a stock that you have high conviction on that maybe is going to rip 100% on you, but you have some high conviction that it's going to appreciate in value.
Gillies: Yeah, it's a way of leveraging slow-and-steady, right? Slow-and-steady wins the race, and bull call spreads can be really fun ways of leveraging that slow-and-steady return.
Sciple: All right, folks, so that's a covered call, bull call spread are both two strategies you can try out if you're interested in learning about options. Before we go away, for both of you, both the Jims that I have here. You mentioned Robinhood options becoming very, very popular, at least throughout 2020, what would you say to folks who are just getting started, last words of advice to them?
Mueller: If you're a part of a group that is doing this kind of together, like, your friends are doing this in trading, don't believe everything they say to you on all their fantastic wins, because I bet they're not telling you about their fantastic losses too. We hate to look stupid in front of others, we hate to admit that we made a mistake. So, we're probably not reporting our losses, and if all you hear, if all the echo chamber-like things that you hear from your friends is, everyone is making money, how come I'm not, they're losing money too, trust me. If they're saying, oh, I haven't had a single loss. They're lying to you, man.
Gillies: I don't believe you. And, look, Fools, Jim and I, I'm not sure, Jim, when you started using options, I can see my third decade looming in terms of my own personal options.
Mueller: I'm coming up on one decade.
Gillies: Yeah. OK, so I guess I'm older than I look. No, I'm probably not.
Mueller: No, you started earlier, you're younger than me.
Gillies: I did start early. You know, I was in my 20s, and I'm no longer in my 20s, but the key part of this is, as Jim says, they're lying to you. And, look, I'll flat out say, I have probably made every mistake you can make in using options over the years. If you had a good three hours and a nice bottle of Bourbon, we could enumerate my errors over the years. I wouldn't change a thing; I learned from all of them. Fortunately, I've been lucky, fortunate, smart occasionally, to mitigate, because I never lost sight. And, Nick, what you've just asked is, what's the thing you'd impress? I never lost sight of the risk and reward.
So, even when catastrophic things happen, and I've had a couple of things which were like, well, that's going to leave a mark, you know, I always knew, going in, here's what my potential risk is. And so, you can at least recover from that and then you also have other various rules which you might impale on your portfolio. So, you know, I have a certain position size, a certain amount of leverage I'm willing to take. And a willingness to cull things that don't work. But always, always, always know your risks. And I guarantee you, people who are newcomers to using options, who are finding it out from some of the apps, and I hate to bang on Robinhood but I'm going to, it's almost too easy, people are using too -- people are using leverage they don't understand and they're having a good time.
And if I can just close with one quick example, there is a particular type of strategy called selling puts, which I'm not going to go into, but it's very similar to covered calls in terms of risk/reward profile, but it's also one of the riskiest things you can do if you don't really fully understand what you're doing. And the problem is, and I've seen this happen over and over and over and over again is, someone takes a small position, like, does a small position to try it out and it works out and they make a few hundred bucks and they feel good. And they'll do it again, and it works out, and they make a few hundred bucks and they feel good. And they start to increase the size of their bets, so instead of doing one contract, they do two, and it works out. And now, they've made double of what they made before. And so, now they're starting to gain some confidence and, boy, isn't this fun. And I'm going to sell five puts, I mean, upsize my original bet by a factor of five; and it works out. Well, now I'm an expert, right. Now, I'm going to teach classes on how well I do at this. And the next time I upsize to 10 contracts and the underlying stock falls 30% and you get wiped out.
Mueller: And the reason they get wiped out is because by selling that put you are promising to buy the shares at the strike price. The owner is going to sell them to you at the strike price; remember that's what the put option is all about. The owner gets to sell at the strike, the seller has to fulfill the other side of that.
Gillies: Yeah. Remember I said, it's akin to, if you buy a put, it's like buying insurance; if you sell a put, you're the insurance company, you're selling insurance. And what happens to an insurance company that sells more insurance than -- you know, it sells hurricane insurance in a hurricane corridor, what happens when a hurricane comes through to that insurance company? It goes bankrupt. So, don't be that guy.
Sciple: Right. So, fundamentally, understand your risk, keep that in your mind at all times, don't fall in love with the upside that could happen to you. And I think a fundamentally important thing to realize is, if you don't understand what your risk is, you're gambling. And more often than not, you're gambling. I mean, even folks who walk into the casino, at least you know what your odds are. If you don't understand your risk, it's arguably even worse than gambling. So, make sure you understand what you're doing, be cautious, dip your toe in and lean on resources that you have, whether it's at The Fool or other places online.
Jim Gillies, Jim Mueller, thanks so much for joining me, to share all your options knowledge. If folks want to reach out to you and ask some more questions, where might they be able to find you?
Mueller: They can't ask us questions directly, because we're not allowed to give answers privately, but if you want to join the Option service by way of joining Total Income, drop me a line at [email protected], and I'll send you a link where you can sign up for the Option service. We have a bunch of boards, a bunch of experienced members who are willing to answer questions, and a whole bunch of educational resources.
Sciple: Thanks for joining me on the show, guys.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.
Thanks to Austin Morgan for making us sound so great. For Jim Mueller, and Jim Gillies, I'm Nick Sciple, thanks for listening, and Fool on!