Monday, May 23, 2011

Options: Weapons of Mass Destruction or a Viable Value Investing Tool?

Warren Buffett famously once called options "financial weapons of mass destruction."  And, if you look at the dangerous uncapped liabilities that options can represent in a balance sheet, his description may, in fact, not be overly dramatic.  After all, marking to market options, especially short sold derivative positions can wreck havoc on a firm's financial wellbeing.  Derivatives were the cause of the brutal destruction of AIG and lent in large part to the severity of the recession of 2008 - 2009.

Sure, there are some daunting reminders of the destructive power of options.  But, to you as an individual investor, specifically a new value investor, is there any value in using options on your positions?

First thing is first-- a derivative contract is something that derives its value from that of something else.  For example, a derivative on Pepsi stock derives its value from the value of Pepsi's stock.   For an institutional investor, buying a derivative like a futures contract may be preferable to buying the stock itself-- after all, derivatives can be more liquid than the underlying security, especially in the case of bonds and credit default swaps-- or they can allow a large investor to establish a position in a stock without pushing around the stock price as significantly.  In some cases, it allows them to conceal their true exposure to a particular stock which can allow them to secretly acquire a company without the alarm bell ringing.

Thanks to the liberalization of the derivatives market, these things too are available to anyone with a brokerage account and a willingness to engage in more complicated financial endeavors.   Consequently they have become a very hot topic, and some extremely complicated arrangements involving derivatives are becoming more and more commonplace.

But are they right for people like us?

Well, in certain arrangements, I would say yes.

Many value investors argue against the use of a covered call because it limits upside for a period of time.  Yet, I think that the traditional covered call has some serious merits worth considering for a value investor.  It is unclear what Graham would have thought about using covered calls, since options were not available to him.  I suspect that value investors would be split on this issue.

Yet, practically, I have found some excellent value in covered calls when I have deployed them upon entry to my stock positions.  Whether or not they are theoretically sound, I don't know, but they certainly have worked well for me in the past.

Let me illustrate to explain what a covered call is.  (Here is a decent explanation for beginners)

Suppose I buy 100 shares of LNG (Cheniere Energy) at $10.04, and sell the June expiration $10 strike contract for $0.85.   When this transaction happens, I pay out $1,004, but also receive $85 back- Thus, I only actually pay $919 out, or the equivalent of $9.19 per share.

So when June 17th (the expiration day for this contract rolls around), where am I exactly?

Well, if the stock price has stayed above $10 per share, there is a good chance that my shares will be taken away from me and $1,000 will be deposited into my account.  This will create a gain ($81) because, remember, we only paid $919 for this arrangement of shares and option contract.  $81 / $919 is a gain of 8.8% in less than a month.  This is a very acceptable outcome.

If the stock drops below $10, I will not have my stock taken away from me.  Yet, instead of being in the position of having paid $10.04 for this stock, I will have paid $919.  Thus my break-even point becomes lower for this stock.  Even if the stock drops to, say, $9.80 per share (lower than the price I bought the stock), if I sell the stock on the 17th of June I will profit.

The only point that I will be kicking myself, then, is if the stock shoots up to, say, $15 per share.  I will have lost out on a lot of the upside and only collect my 8.8% gain.  Still, not a bad gain, just not as much gain as I could have had.  And if the stock drops to $0, I lose out, but then again, so would someone who solely had a long position in the stock (and they would lose more!)

Thus, in all ways, the covered call is a risk reducing strategy.  This is part of what makes me gravitate towards it- being a naturally risk averse value investor, I prefer using options as a hedge vs. options to speculate.

Additionally, the covered call works very well with the traditional value position.  Many of the companies that I examine for purchase are at 52 week lows, and thus their volatility is exceptionally high.  This often results in all options being sold at a significantly larger premium than one would normally expect.  Furthermore, by selling the near term options (the options with the closest expiration) I am only limited in my upside for a short duration (never more than a couple months.)  This is a serious boon to a long term investor.  I know that it is very unlikely that many of the companies I am interested in will take awhile to turn around and I am glad to have someone else pay me to wait for the pleasure.

Derivatives can be complex, but in reality they function on rather simple mechanisms.  As a value investor I urge you not to shun them as a weapon in your arsenal.  The covered call is one of the simpler applications of a derivative and yet, to this day, I still find it to be the most effective.

Stay well until next week!

1 comment:

  1. I find that the best measurement of how great a bargain a stock is is a very low price to sales ratio. It clearly defines value in a stock more than anything else.