Hi everyone,
I am a brand new irregular, very much impressed by the rich content of this site, Travis’ contributions and the lively discussions in the community. This is my first post.
I consider myself a long-term investor, not a trader, who is using options to build-up stock positions and manage risk. Fifteen years ago, I was a CANSLIM swing trader, ten years ago I was trading non-directional iron condors on RUT and five years ago I thought I could consistently make profits trading risk reversals on short term VIX options. After much reflection, counterfactual analysis and programmatic backtesting, I came to the conclusion that options are priced to perfection in the short-run. In hindsight, the evidence has always been right in front of me as the only consistently profitable part of my portfolio has been my long-term buy and holds. I do not regret my long and steep learning curve, today I enjoy investing more than ever (this exceptional bull market of course helps…).
I noticed that some people have expressed interest for more discussions on option strategies, so I happily try to contribute (sporadically). Please understand that, by no means, I claim that my method of investing is better than anyone else’s. Investing with options is all about making trade-offs and bringing your choices in line with your risk tolerance. There is not, and never will be, a holy grail method of option investing (despite of what several guru’s will try to make you believe). What I explain below is nothing fancy or high-tech and people well versed in options can skip this post, there is so much else to read on this forum!
Inspired by another thread, where an interesting newsletter promising 100x returns is being tracked, I yesterday decided to open two new positions, one in $NNDM and one in $OPTT. Yesterday’s closing prices of these stocks were 14,53 and 5,02 respectively. Rather than outright buying 100 shares of each, which I will use as a benchmark below, I bought what is called the ‘synthetic’ equivalent, namely I bought one call and sold one put with the same strike and the same expiration date. To lower my debit paid, I also sold an out-of-the money (OTM) call, essentially making these positions synthetic covered calls. Here are the specifics:
For $NNDM:
Bought May21’21 strike 10 call for 6,8 debit
Sold May21’21 strike 20 call for 3,7 credit
Sold May21’21 strike 10 put for 1,85 credit
Total combo: 1,25 debit or 125$ paid
For $OPTT:
Bought May21’21 strike 5 call for 2,2 debit
Sold May21’21 strike 10 call for 1,4 credit
Sold May21’21 strike 5 put for 2,1 credit
Total combo: 1,3 credit or 130$ received
Note that, combined, these positions have hardly influenced my total available funds. Yet, for sure, I am now invested in these stocks as I will explain below. So here is a first reason why I think this method can be beneficial, at times, and for some of you: when your newsletter on a regular basis comes out with new recommendations, and you try to buy each and every new recommendation in fear of missing out, many people face difficulties financing the new recommendations and therefore, reluctantly, see themselves forced to sell parts of another winning position. By switching to options, you buy time, in this case until May 21 of this year.
Because what is going to happen on that day? If $NNDM is still under 20 and $OPTT still under 10, I will exercise (or be exercised) on my position and essentially buy 100 shares of $NNDM for 11.25$ (10$ long call strike + 1,25 debit) and 100 shares of $OPTT for 3.7$ (5$ long call strike – 1,3 credit). Note that I have fixed my purchase price yesterday, although I will own the stocks only in May. I buy these stocks at a 22,5% and 26% discount, compared to yesterday’s closing prices, respectively. This is obviously a second reason why you could consider buying a synthetic position.
Are these two reasons combined too good to be true, in other words, what is the extra risk, compared to simply buying the stock immediately? Well, the same as any covered call position really, I have put a cap on my upward profit potential (on top of the downward risk of the stock going to 0, which a buy and hold stock buyer also faces). If $NNDM closes above 20 and $OPTT closes above 10, I will (only) make 875$ (=(20-10-1,25)*100) and 630$ (=(10-5+1,3)*100) profits and not own the stock and maybe miss out on some extra profit by that time. Does that bother me? Not really, but maybe it does bother you. This is exactly the trade-off at play here, and the outcome, i.e. your choice how precisely to invest, will depend on your risk-profile and your trading psychology. I am not really concerned because I know that I will set-up a new synthetic position and eventually the stock will let me in, as no stock shoots straight to the moon. If these stocks really have 100x potential, which will take them very likely at least a decade if not more, I can afford to wait a quarter (note that I am buying and selling options 3 months out) or more now.
When owning the stock in May, it is likely that I will try to lower the purchase price further, by selling another OTM call, this time turning the position in a standard covered call. Of course also then, there will be similar risks as described above to be considered.
But, in sum, I think it is worthwhile considering this method when constructing a well-diversified portfolio of micro/small cap stocks, certainly if you often find yourself in difficulties financing them. For reasons of margin requirements, the method can only be used for lower priced stocks, but for many microcaps that is the case anyways.
I hope this post was interesting for some option enthusiasts here.
Good luck and to paraphrase Travis: thanks for reading!
This is a discussion topic or guest posting submitted by a Stock Gumshoe reader. The content has not been edited or reviewed by Stock Gumshoe, and any opinions expressed are those of the author alone.
Hi T_T_P. Very interesting approach. Thanks for that share. I am starting looking at options trading and so keen to learn such solutions. Eager to hear from you more if you happen to apply another approach and be willing to share. Regards
Hi chmarpio, thanks for your message, I am glad my post was helpful. I will provide an update on the two positions in May.
On the upside risk of missing out, I should have added that in case I am being exercised, a 78% (875/1125) and 170% (630/370) return in three months is nothing to complain about. And as I wrote, I can always jump in again the next day. That is why I like to track and compare the benchmark case of buying stock outright and the alternative of buying synthetic on all my positions. It is like a horse race, you will see it is fun (and over time the synthetic is hard to beat!)!
I am personally always much more worried about the downside risk of microcaps going bankrupt. Take $OPTT as an example. Deriving energy from sea waves sounds like a great idea on paper, but looking at the monthly chart of the stock, things do not look very exciting. And if you look at the very volatile daily chart, it is not hard to conclude that so many retail traders have lost money on this stock. Either they sell in panic when there is a big price drop or, worse, they put in stop-loss orders, which the moneymakers love to trigger to make some money themselves. It is just the way most retail traders manage downward risk. What they overlook, is that instead of selling stock, you can also manage the downward risk by selling time premium on your OTM call. I never put in stop-loss orders and I try, as much as possible, to never sell stock. That is why I am forced, from a risk managing perspective, to sell time premium in my covered call positions. If you keep following this post, you will see that I will not stop my covered call position on stocks like $OPTT until my purchase price is down to zero and bankruptcy risk is completely hedged. The nice thing is that, looking at the rich premia of the options, it is likely that I will get there maybe already within a year. So fingers crossed that $OPTT survives 2021 (which it probably will do). And I can assure you, once you have a stock for free in your portfolio, it is psychologically much easier to be a long term investor. Best wishes.
Hi T_T_P,
I will second that! Thank you for an excellent lesson – clear, concise, and thorough – smooth writing quality – and at the exact level of complexity for this second semester student. Particularly the part about the risk assessment. I’ll look forward to anything you might have to say in the future.
Hello T_T_P,
Love your writing style and the easily understood information. New to options, but this appears to be a fantastic alternative to rushing to buy each and every stock mentioned with a limited account. I will definitely be following this thread and look forward to more posts if you have the time and inclination. Thanks again!
Hi timcoahran and lacasaless,
Thank you for your kind words, very much appreciated!
I am currently discovering the content of the site further, mainly reading (and learning from) Travis’ Friday Files. Very exciting!
I noticed that Travis often writes something like: “I like stock XYZ, but would not buy it today at price A, because it is too richly valued by any reasonable metric. I’d only consider nibbling at price B (where price B is then, say, 20-25% lower than price A).”
For the stock investor who wants to follow Travis’ advice, there is really only one thing he or she can do, i.e. submitting a limit buy order at price B and start waiting (and hoping) that the price drops from A to B. If there is one lesson I have learned in the stock market, then it is that when you start hoping for a price change, you are doing something wrong.
How different is the situation for the option investor! Admittedly, it will not work every time, but it is certainly worth investigating the option tables whether or not you can fix your purchase price of stock XYZ at price B already today, simply by using the technique that we are discussing in this thread (recall that I bought $NNDM and $OPTT at a 22,5% and 26% discount). This might be surprising for readers unfamiliar with options, but it is, I think, a very important insight and useful advice, given the many recommendations posted on this forum.
What is the worst thing that can happen? Well, that at the end of the story, both the stock investor and the option investor find themselves in a situation where they do not own the stock. But their situations are far from identical and the asymmetry between them is crucial to understand. The stock investor does not own the stock because the price never dropped to B. The option investor does not own the stock because the price, at expiration of the combo, exceeds the strike price C of the OTM call option that was sold. The stock investor is left empty-handed, the option investor pockets (C-B)*100. Anyone looking for a motivation to start learning options, ask yourself: Who of these two investors would you rather be?
The discussion we are building here is, in my mind, also very relevant during the inevitable, sudden and scary market selloffs, like the one we just witnessed in the markets in the last 48 hours. To those investors that sold (parts of) profitable positions in panic, it is worth repeating that downward risk can be managed not only by selling stock, but also by selling time premium on options covered by your stock position. To those investors who yesterday lacked the funds to bottom fish and open new positions, consider buying synthetically (if margin requirements allow). And, finally, to those investors that threw good money after bad while catching falling knives, rationalizing the act by reassuring themselves that they were ‘averaging down’, be careful. When the dust settles, you have not only decreased your average price, but you also increased your total exposure in the stock. Not only might the position sizing balance of your portfolio be disrupted, you also unexpectedly further depleted your available funds to buy new recommendations in the future.
By consistently selling time premium in your covered call positions, you are essentially also averaging down, quarter after quarter, but the important difference is that you keep your position size fixed at the original position of (a multiple of) 100 shares. Managing risk, by routinely selling time premium, also takes away the psychological pressure of ‘having to do something on a big red day in the market’. Peace of mind, strong hands and confidence in your investing method are likely all important ingredients to long-term investment success.
I hope some of the above was helpful for your own investments. Good luck and all the best!