I’ve mentioned before that I make somewhat regular use of options in order to generate additional returns for my portfolio, and while I think the core mechanisms have been explained by me before, I’ve recently received a comment on one of my posts requesting additional details.
So today we are going to talk about my experience with options, what I do with them, and some of the mistakes and errors I’ve made.
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What are options?
According to investopedia:
The term option refers to a financial instrument that is based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they decide against it.
In short, options are financial instruments that give you the option to buy or sell a given underlying security.
There are 2 types of options:
Calls - Give you the option to buy a security at a set price
Puts - Give you the option to sell a security at a set price
Of course for each option being bought, there is someone selling that option, this effectively means that when you sell an option, you’re selling an obligation.
Calls - Gives you the obligation to sell a security at a set price
Puts - Gives you the obligation to buy a security at a set price
Additionally most options are denominated in blocks of 100 securities, so usually when we say “We bought a call for WU 0.00 ” that actually means we bought the right to buy 100 shares of WU 0.00 .
This leverage can make options extremely risky, since it can quickly turn a seemingly small change in the underlying value, into a massive loss.
This issue with leverage is compounded when you sell calls, since there is no limit as to how high the shares can go.
You don’t want to get caught having sold a call with a strike price of $10, when the current market price of the security is $10000!
How I use them
I have done several different types of options plays:
The only I haven’t done was buy puts, since it just has never fit my purposes.
Of these trades, the only one I did well in, and the only one I still do is Sell Puts.
I regularly Sell Puts, usually 1 to 4 put contracts per month, bringing in a small amount of premium each time.
Generally speaking I sell puts on companies that I already own, and that I would like to purchase more of, at strike prices that are below what I would consider a safe purchase price for the security.
I sell them very much out of the money, hence the premiums are low, though I also don’t keep any cash on the side for them so that increases my return on equity.
This doesn’t mean I haven’t made mistakes before, and indeed I went over a big mistake i made last year here:
In general though selling puts has been profitable and stress free, so I’m happy to keep doing it going forward.
The same cannot be said for selling calls.
I only did this once with a single O 0.00 call that I sold. This was not a "naked call" that I sold, so I did not really risk much.
Indeed the strike price that i sold it at was above my cost basis for the stock, so even if it had gotten called, I wouldn't have lost anything.
The problem that I had there was a psychological one, I simply couldn’t bear the thought of selling the company. I like O 0.00 and although I think its probably overvalued, the stress of having it potentially taken away from me was too much.
I didn’t enjoy the experience (even though it was profitable) and so I chose not to sell calls anymore, even if I could make some premium that way.
Finally there is buying calls.
This has not been successful for me, and I have no intention of doing it again.
Once again, I purchased a single call in INTC 0.00 and of course I did it when the company was at an all time high, and during a period of heavy volatility for the the stock.
This was a LEAP expiring in january 2024, and has simply done terribly having lost almost 100% of its value. This call that I purchased for $1200 now sells for around $10.
I remain bullish on the company, and its turnaround, and I remain invested in it, and I still own that call.
But its clear to me that I’m not good at predicting short term market movements, and so I won’t make any further use of buying calls.
I consider it money well spent, since it gave me a clear clap in the face when it comes to sticking the course on value investing.
What about you? Do you use options? Are you careful with how you use them?
Let me know in the comments below.
i use options the same way you do. Sell puts of stocks i do wanna own at a price with a good margin of safety from my fair value price.
Also sell calls, but have no fear of selling them, with the options premium plus the capital gains. if for some reason i got assigned, i would just be a bit more agressive in selling puts for that stock....
Thanks for the article TiagoD! Similarly, I use ‘premium’ income (from selling puts) to bolster my dividend portfolio purchases. However, with the growing risk of recessions/bear markets ahead will you be changing your approach to spellings puts? Eg adding a greater safety margin to your valuations & strike prices…?