Every investor familiar with stock exchange, even a beginner, knows what equities, bonds and futures are. Those who know what an option is and understand how to use them are much harder to find. Options can be of speculative nature but they also secure your gains and profits. The latter is an aspect that you will know more about after reading. How can you ‘insure’ your position, which already gave good return, but you’re not sure whether the asset could still grow and you don’t want to close the position yet?
I was inspired to write this piece after reading an article about an investor who in 2010 bought uranium futures. His position gained him 500%. He neither sold nor did he insure his contract. The Fukushima tragedy in 2011 pushed uranium price off the cliff and he barely made it without any loss.
Before I explain the strategy I want to quickly say what an option is, what types are there and how can we use them.
1. What is an option?
When we talk about options we mean a contractual financial instrument where two parties have clear rights and obligations. Holder (buyer) after paying price of an option (premium) has the right to buy or sell depending on the type of the option, underlying asset from which this option derives. He can do this at the strike price (price on the contract) before expiration date (time value).
Exercise – using the right given by an option. For example selling or buying underlying asset before expiration date after which the option no longer gives any right or obligation to the parties.
2. Types of options
There are two styles of options and two types. First styles. There is American and European option. Difference is that American is more expensive but give the owner ability to exercise before the expiry date. European option may be exercised only at expiration. This difference makes American options more expensive.
Secondly, types of options. If an option is going to get more expensive along with the underlying asset it will be a ‘call’ option. If option is going to get more expensive when the asset gets cheaper it will be a ‘put’ option. Options can be bought or sold but due to the fact that selling (writing) them entails huge risk and sooner or later makes someone bankrupt I will focus on buying them only.
From statistics we can read that writers of options earn on 80% options sold. It may seems like a great idea but the truth is more complex. Writer of an option earns 5-10% depending on the value of an underlying asset. This means that in 4 out of 5 you can earn when you know what you are doing. Unfortunately 20% of losses, especially with volatile prices, is enough to wipe out significant share of your capital.
Let me repeat again: I do not advise anyone to write/sell an option even if you are not a beginner.
The Call Option
Let’s assume there is an index containing portfolio of the biggest corporations in a country. Blue line divides our chart in two parts. Upper part is a return and part below is a loss. When you exercise your option you use ‘strike price’. In our example strike price is equal to 3000. Red line shows us how much we can earn or lose depending on the price of the underlying asset. From chart above you can see that this option’s cost was 100. If the asset’s price doesn’t rise above 3000 owner of this option will definitely lose money.
Part of the chart when we see red horizontal line tells us that the price of the asset is so low it doesn’t make sense to exercise the call option and buy the asset for 3000. You can buy this stock cheaper without having to pay for the option. When the owner of this option won’t exercise it before expiry date, he will lose the price of this option (premium) – 100.
When price of index rises to 3200 exercising this option will give a profit to the option owner. Exercising a call option requires the seller of the option (writer) to sell underlying asset (here index) at the agreed strike price – 3000. Afterwards, selling this asset for 3200 which is the market price puts us at +200. We paid 100 for this option so profit equals to 100.
The Put Option
If we buy a put option and price of the index drops below strike price (3000) we can exercise it with profit. We require a writer of this put option to buy an index from us for agreed strike price 3000, after we will buy it in the market for 2900. We won’t make any money on this transaction even though, price fell. Unfortunately the decrease in price was too small and after covering premium paid for the option we are back at square one with no profit.
Countless books were written about options trade and I am not planning to explain all the details of this instrument. If you are interested in this form of trading I encourage you to research topic thoroughly. What you will get from me is an explanation of one strategy used to secure your position on which you already earned money when a trend change is possible. Buying a put option on an asset to secure already earned profit without closing our position and as a result without losing opportunity for further gains.
3. Buying put option as a security strategy
To illustrate how this strategy works I will use a chart of silver’s performance in 2010-2011. Let’s assume we bought silver around September 2010. We paid 19 USD for 1 oz and for simplicity let’s exclude all taxes and other commissions. We are securing our ounce with an option (we use simplification here as there are no options for only one ounce). Without commissions and taxes our profitability chart looks like the one below. If price of silver goes over 19 USD we will make money. If it doesn’t or it falls below 19 USD we will have to close our position and take the loss.
Buying ounce of silver in 2010 was a very good decision. Price of silver raised to ~29,5 USD but suddenly it starts to fall and now price is at 28.5 USD. The RSI is above 60 and situation becomes more uncertain. We start to wonder whether it would be better to close our position and be happy about 50% profit while losing chances for further earnings if the price goes up even higher. We need to decide if we wish to risk losing already earned profit for the potential of further gains.
Instead of worrying we can buy put option on silver. In our example it costs us 1 USD. Our earnings of 9.5 USD will be smaller – 8.5 USD but we won’t lose this sum and we can earn even more.
The Profit/Loss chart of our option looks like this:
We had to buy an option so we paid 1 USD but in case price of silver falls below 28.5 USD we will make money on this option. If price of silver goes up, we make profit from silver ounce we own minus price of the option.
When securing our position our portfolio consists of 1 ounce of silver and 1 put option. We bought silver for 19 USD and secure it at 28.5 USD/oz. Chart of possible earnings looks like this:
In red we see our profit from portfolio (no matter the direction of price change from 28.5 USD). Adjusting size of an option to our position on an asset made sure that our profit cannot go lower than 8.5 USD. This is the goal of our strategy. When price of silver goes up, we earn money on our metal and we can forget about the option or we sell it before it expires. When silver gets cheaper we lose on our ounce but the option we bought will return amount we lost. Possible losses are hedged and nothing stops us from increasing our profit when silver appreciates.
We know from history, metal got more expensive. Thanks to our strategy we were able to stay calm and not worry about our profit that we earned and in addition still our asset can appreciate. If we sell our portfolio for 37,34 this is how our chart of our profits would look like:
4. Advantage of an option over futures contract
When we talk about futures contracts, profits or losses are not anyhow limited. Options are built in a different way. They consist of merely cost of opening position and possible profit if price goes in the right direction.
This type of hedging is used by institutional investors, insuring future revenues of a fund or entity against the price change of an asset they invest in. Our goal is to maximise our profits therefore futures are not the right tool for us.
5. Adjusting amount of options to taken position
Options have on big disadvantage: they are not common and this makes their number small. Especially when you are small investor the threshold is high. Good example is CME’ Comex where you can find options on silver you can find there starts at 5000 oz. How can you solve this problem is to look for precious metals ETFs and buy an option on them.
The amount of options you want to secure your position in equities, commodities or other instruments depends on correlation and risk. Quite often options give you exposure on popular indices or future contracts. Performance of an asset we opened our position in may not be 100% identical to performance of the asset we buy option on. Just like I said before – options are not so popular and sometimes we have to look for a compromise and pick the most similar option that mimics our asset.
This is how the theory looks like. In part two I will use examples available from brokers I know and work with. I will show their price, possibilities and risks.
Independent Trader Team