The decision to go long (buy options) or short (sell options) involves analyzing opposite sides of the risk spectrum. The interesting feature of options is that strategies cover the entire range of risk, often with only a subtle change. Long options are disadvantageous in the sense that time works against the buyer; time value disappears as expiration approaches. Given the certainty that time value evaporates by expiration, it is difficult to overcome that obstacle and produce profits consistently. The less time until expiration, the more difficult it is to profit from buying options; and the longer the time until expiration, the more the speculator has to pay to pick up those contracts. Long options can insure paper profits, but the more popular application of long options is to leverage capital and speculate.
There are circumstances in which you, even as a conservative investor, will want to go long in options. For example, following a large price decline in the market in a short time span, prices of strong stocks are likely to rebound; but not being sure where the market bottom is, you may tend to be the most fearful when the greatest opportunities are present. In these cases, buying calls allows you to control shares of stock, limit potential losses, and expose yourself to impressive gains—as long as prices rebound in a timely manner. This is a speculative move, but even the most conservative investor may see market declines as buying opportunities, especially if a small amount of capital is at risk.
This does not mean that going long with options is conservative or even advisable. But every investor holding a portfolio for the long term knows how market cycles work. Options present occasional opportunities to take advantage of price swings. When overall market prices fall suddenly, conventional wisdom identifies the occurrence as a buying opportunity; realistically, such price movements make investors fearful, and it is unlikely that many people will willingly place more capital at risk—especially because the paper position of the portfolio is at a loss. So, buying options can represent a limited risk for potentially rewarding profits— an opportunity to buy more shares of stocks you continue to think of as long-term hold issues.
The same argument applies when stock prices rise quickly. Sudden price run-ups are of concern to you as a long-term conservative investor. The dilemma is that you do not want to sell shares and take profits because you want to hold the stock as a long-term investment; at the same time, you expect a price correction. In this situation, you can use long puts to offset price decline. You create a choice using long puts. First, if and when the price decline occurs, you can sell puts at a profit; the short-term profit from puts offsets the price decline in stock. The second choice is to exercise the puts and dispose of the stock at the strike price (which would be higher than current market value). You would take this path if your opinion of the company were to change, so that your hold position moved to a sell position along with the decline in stock value.
You are likely to stick with the conservative path: As long as you want to hold the stock for the long term, you are willing to ignore short-term price volatility. Even so, few investors can ignore dramatic price movement in their portfolio. When prices plummet or soar—especially as part of a marketwide trend as witnessed in 2008 and not for any fundamental reasons—the change in price levels may be only temporary. The tendency for some investors is to panic and sell at the low or to buy at a price peak. In other words, rather than following the wisdom "buy low, sell high," investors often react to short-term trends and "buy high, sell low." It helps to ignore short-term trends and to resist the human tendencies toward panic or greed; and as a conservative investor, you are more likely to equip yourself with a cooler head during volatile times.
Even so, you can retain your conservative standards and, at the same time, use options to exploit the market roller coaster. There are risks involved, but the alternative is to take no action but a wait-and-see approach. Options can help you deal with price volatility on the upside or the downside for fairly low risk and without losing sight of your long-term investment goals.
The question of speculative versus conservative is not easily addressed. Yes, using options to play market prices is speculative; but at times, you can take advantage of that volatility without selling off shares from your portfolio. The same observation applies on the short side of options, where risks are far different and market strategies can vary.
When you short options, you do not have the rights that buyers enjoy. Buyers pay for the right to decide if and when to exercise or whether to sell their long positions. When you are short, you receive payment when you open the position, but someone else decides whether to exercise. Time value works to your advantage in the short position, so you can control the risks while creating a short-term income stream. Risk levels depend on the specific strategy you employ.
The highest risk use of options is the uncovered call. When you sell a call, you receive a premium, but you also accept a potentially unlimited risk. If the stock's market value were to rise many points and the call were exercised, you would have to pay the difference between the strike price and current market value at the time of exercise. For example, let's say you sold a call with a strike price of 40 and you received a premium of 8 ($800). That reduces your risk exposure to as much as $48 per share (strike price of 40 plus 8 points you received for selling the call)—but without considered trading costs. However, what if the stock's market value rises to $74 per share before expiration, and the call is exercised? In that event, you must deliver shares and pay $3,400 upon notice of assignment ($74 per share current market value, minus $40 per share strike price). Your loss would be $2,600 ($3,400 payment minus $800 you received for selling the call).
The uncovered call is the highest risk strategy; in comparison, the covered call is the lowest risk strategy. If you own 100 shares, you can deliver those shares to satisfy exercise, no matter what the market price is. Upon exercise, you keep the premium you were paid. The greatest argument against covered call writing is the chance of lost appreciation. In the previous example, had you merely held onto your 100 shares, their value would have increased to $74 per share. Because you wrote a 40 call, you would be required to sell them for $40 per share. As a counter to this argument, a couple of points have to be remembered. First, the frequency of large price increases should be studied in comparison to the certainty of option premium you earn for selling calls. Second, as long as exercise creates a profit in the call as well as capital gain in the stock, you earn a profit. For example, let's say your original basis in the stock was $32 per share and the stock is currently valued at $38 per share. You sell a 40 call and receive a premium of 8 ($800). Upon exercise, your profit is $600 capital gain on the stock plus $800 profit on the short call (plus any dividends you received during the holding period). That is an overall 43.75 percent return ($1,400 ^ $3,200). Including stock profits with option profits is not entirely accurate because the two are separate transactions. However, in picking a strike price for covered call writing, you need to evaluate the outcome in the event of exercise. Your selection of one strike over another certainty affects your total profit on the exercised covered call.
The capital gain created when a covered call is exercised may produce impressive levels of profit as long as the basis in stock was far lower. However, for the purpose of comparing option returns under different outcome scenarios, capital gains are not normally included as part of the analysis. If you owned stock and simply sold it without writing options, you would earn the capital gains, so stock and option profits in covered call examples are not tied together as part of the comparison. In the previous scenario, the option-only return, you received $800 for selling a call when the stock was at $38 per share. This is a 21.1 percent return ($800 ^ $3,800). To make this comparable to other option returns, you also need to annualize this return, meaning the yield is recalculated as if the position remained open for exactly one full year.
The short call may be high risk or highly conservative. In comparison, the short put has varying risk levels depending on the purpose of going short, your willingness to accept exercise, and the amount of premium paid to you at the time you open the short position.
The decision to employ options in either long or short positions defines risk profile; the definition of conservative is rarely fixed or inflexible. It is more likely to define an overall level of attitude about specific strategies while acknowledging that strategies may be appropriate in different circumstances. It is all a matter of timing a decision based on the current status of the market, your portfolio, and your personal decision to take action or to wait out volatile market conditions.
Was this article helpful?