By: R.M. Valdez
Boxed out… again.
It happens more than I care to admit in social situations. It all starts out friendly enough… “Oh, what do you do for a living?” To which I eagerly reply, “I work in investments, specifically in options.”
Then I see it start to happen. At best, I can see the glassy look take over their eyes. At worst, all out fear and panic at the use of the word, “options.” Then, smiles fade from their faces and shoulders start to turn away from me. They are boxing me out. They start mumbling about having to make a phone call or freshen up a drink, ultimately leaving me to explain options to the wind.
Unfortunately, this is a common conversation of my social life. Options have taken on a seedy reputation and my affiliation with them seems to lower my social standing at cocktail parties. What I often tell the wind, as I stand lonely at the edge of the party, is that options aren’t as bad as one might think.
It’s not the options’ fault for getting a bad rap; instead, it’s the culture around options. Specifically, the “smartest guy in the room” culture. The investment profession has gotten really great about making itself sound like the smartest guy in the room. Through the use of phrases like put/call parity, time decay or iron condor, the average investor is systematically shut out of the options conversation before it can even begin.
Setting the nomenclature aside, options can be beneficial to a portfolio for most investors if they would only hear me out. Depending on an investor’s goals, when used appropriately, options can earn additional return streams, lock in gains, protect portfolios from falling markets and much more.
I don’t have enough space in one blog post to explore all the ways options can be used in a portfolio, but if I had to pick only one to explain, it would be Covered Calls or Buy-Writes.
Wait… I’m doing it again!
See, even I am a sucker to the options slang, using unfamiliar terms to explain an investment concept. No wonder I was left standing alone conversing with the wind.
Let’s try this again…
Imagine if you own a summer home, perhaps on a lake or on the beach. It’s not your primary residence, so you don’t live there all the time. What would you do with your summer home when you’re not there? Rent it out, of course.
This is exactly what a Covered Call or a Buy-Write (which is short hand for “BUY a stock, WRITE a call”) does for your stock. It “rents” out your stock like you would your summer home. And for options, just like any rental contract, there are different rental periods the renter can choose: weekly, monthly, yearly. But no matter which period you choose, there is an end date to the rental period or contract.
You would never let another person stay, maybe excluding family and friends, in your summer home without paying you to do so. Rather, you would collect rent from your tenant. Similarly, when entering a Buy-Write, you are paid to “rent” out your stock. This is the most relatable way for me to understand the concept of Covered Calls or Buy-Writes.
On the surface, the initial benefits are obvious…you take an investment you already own and by “renting” it out via Covered Calls, you are able to collect an additional return stream.
Who wouldn’t want to achieve additional return opportunities from an investment they already own? While the summer home rental is a great analogy for Covered Calls, your stock is not actually a summer home, and a Covered Call is not actually a rental contract. There are some additional details an investor should be aware of before entering this strategy.
Specifically, in Covered Calls, your “rental contract” is more accurately described as a contract for the “renter” to buy your stock (at a predetermined price) at or before the end of the contract. So, unlike a real summer rental, in a Covered Call there is the possibility that you might have to sell your stock to the “renter” in the future. And while there are ways to avoid having to sell, an investor should not sell Covered Calls unless they are willing to sell some or all of their stock.
However, if you are happy to have a “renter” pay you up front to potentially buy your stock at a predetermined price and on a predetermined date in the future, Covered Calls could easily benefit your investment portfolio.
It is also worth mentioning that the “renter” will most likely buy your stock if the stock price is currently above the predetermined price of the “rental contract.” For the renter, they are effectively buying your stock on sale, because they can buy it cheaper from you (due to the “rental contract”) than they would in the current market. So, by entering into a “rental contract” you are giving up any potential rise in price above the price listed in the contract.
The two worst things that can happen when using Covered Calls is that you may have to sell the stock and you may lose out on a potential rise in price. These can be easily mitigated by selecting stocks you are happy to sell and by selecting prices at which you are happy to sell. The way you could avoid having to sell your stock would be to buy back the “rental contract” before the “renter” exercises their right to buy your stock. It could be for more than what you sold the contract at but you most likely benefited from some of the price appreciation.
Now that I have covered the obligatory worst-case scenarios and clearly captivated you with my options repartee, I’ll pause and let you freshen up your drink… Just promise to come back.
Now that you’ve returned with your drink and a shared eagerness for options, let’s explore why this makes sense for an investment portfolio.
If you plan on owning a stock, it could do one of three things: go down, go sideways or go up.
So, what happens if your stock goes down? Well, the stock was going to be in your portfolio anyways, but because you collected “rent” on the stock, the portfolio is ahead by the amount you collected in “rent.” Also, if you feel truly confident in that stock and think the drop is temporary, you can use the cash from the “rent” collected to buy more shares of the stock, creating a natural buy-low strategy.
Now, let’s say the stock goes sideways, which means the price stays the same over the “rental contract” period. Having only owned the stock, there would be no gain from the stock itself during this period. But, if you chose to collect “rent” on your stock, the portfolio has a positive return for the amount of the “rent” received.
Lastly, should the stock price rise, if you have the stock only, you are entitled to the entire rise in price. However, if you “rent” the stock out, you are only entitled to increase of the stock up to the price you agreed to sell it at plus the “rent” received during the rental period. This can sound unappealing, especially if you think this stock has great potential to rise, during the rental period, above the agreed upon sell price.
Now, If you think that the stock will rise during the rental period, there are methods you can deploy to gain more of the rising price. One way would be to only rent out part of your stock — think of this as making your summer home into a duplex whereby you collect half the “rent” but allow the other half of the stock to rise without having to sell at the predetermined price. Another way would be to adjust the contract price — setting the contract price higher than the price of the stock today. This allows you to set the contract at a price you believe the price will rise to, but not necessarily exceed, during the rental period. This could give you what I think is the best of both worlds: rise return and rent return.
There you have it! In the time it took to finish the appetizer round at a dinner party, you have gained a better understanding of options. Hopefully, it wasn’t as painful as originally thought.
As for me, since I am tired of standing at the edge of the party, alone, perhaps next time, you will join me. As much as I appreciate my windblown solo conversations, I would much rather discuss options with you.
Until next time…
R.M. Valdez is a contributing author of the Skybird Report and the Director of Investments for Partnervest Advisory Services, LLC. The commentary, analysis and opinions expressed in this article are her own, are NOT a solicitation for the sale or an offer to buy any security, are subject to change at any time without notice, and should not be considered investment advice for any individual. Information provided in the article is obtained from sources which the author believes to be reliable; however, she does not independently verify or otherwise investigate all such information, nor does she guarantee the accuracy or completeness of the information.