Options as a Tool for the Value Investor: An Elementary Perspective (Part 1)
Option trading is no exception. The buyer of an option could find his investment rendered worthless in a relatively short time. By the same token, an option writer (if uncovered) finds herself in an extremely risky position and might incur very large loses, many times the premium received for shorting the underlying interest.
So, why use options when the associated risks are too high? Because options, as other derivatives, might serve the investor to attain some investment objectives (see below Investment Objectives).
Brief History. (Ruffy), (Stocks Options Trading), (CBOE), (OCC), (Nobel Prize).
It is not possible to say exactly when options were first used. There are references about the Romans and Phoenicians underwriting shipping contracts with characteristics similar than those of options. Thales of Miletus (c. 624 B.C. – c. 546 B.C.), the Greek philosopher and mathematician, supposedly bought options for the use of olive presses after predicting a good harvest. He did it not to get wealthy, but to show that he could use his intelligence to acquire a fortune.
In the 1600s, traders purchased option contracts in order to secure the price for tulips.
1848, in the U.S., options started trading officially, the same year The Chicago Board of Trade (CBOT) was created.
1934, the Securities and Exchange Commission (SEC) became the regulatory agency for option trading in the U.S.
1955, Professor Paul Samuelson (MIT) located by chance, rotting in the library of the University of Paris, the 1900 Ph.D. Thesis of a Sorbonne graduate student called Louis Bachelier. The thesis “The Theory of Speculation” proposes a mathematical model to price options and considers that the stock markets move at random. Prof. Samuelson had the thesis translated into English to understand every single word of the work. Once Bachelier’s book was widely known, academics in the financial economics world set about finding the impeccable model to evaluate and to price options.
In the 1960s, some models were developed, but included variables that were not reasonably observable like level of: satisfaction, reasonableness, aggressiveness. When one particular model did not seem to do the trick, more variables were added like: guesses of other traders, defensiveness and so forth.
1968, Fischer Black and Myron Scholes started their research on options.
1973, the first US options exchange is founded, the Chicago Board Options Exchange (CBOE), during the first day of trading, April 26, 911 contracts are issued on 16 stocks. The predecessor of the Options Clearing Corporation (OCC), the CBOE Clearing Corporation is created. That same year; Fischer Black and Myron Scholes published their paper “The Pricing of Options and Corporate Liabilities” in the Journal of Political Economy. Pretty soon traders began to employ the equation to price options. Many authors have further developed on Black and Scholes work, the improvements by Prof. Robert C. Merton stand out though.
1975, the Black-Scholes model is used by the CBOE to price options. The Options Clearing Corporation (OCC) is approved by the S.E.C. as the central clearing corporation for exchange-listed options.
1977, the Securities and Exchange Commission (SEC) authorizes put options, trading of this derivative begins.
1980, total annual trading volume, cleared by the OCC, exceeds 100 million contracts.
1983, options on stock indexes are introduced.
1989, CBOE begins trading options on interest rates.
1990, Long Term Equity AnticiPation Securities (LEAPS) are created. LEAPS are options with a contract life of up to three years.
1997, Myron Scholes and Robert C. Merton are awarded the Nobel Prize in Economics for their seminal research and the development of the options valuation model. Fischer Black (who died in 1995) is recognized as a contributor by the Swedish Academy. The prize is not given posthumously.
1999, total annual trading volume, cleared by the OCC, exceeds 500 million contracts.
2000, the SEC links the U.S. options markets.
2001, The Securities Industry adopts pricing in decimals, instead of fractional pricing, narrowing bid-offer spreads for investors.
2004, total annual trading volume, cleared by the OCC, exceeds 1 billion contracts.
2010, total annual trading volume, cleared by the OCC, exceeds 3.9 billion contracts, 92.6 percent are equity options.
The following is an elemental description of options for illustration purposes only. The reader is advised not to engage in any option trading until these derivative securities and their risks are thoroughly understood.
Options description. (CBOE), (OCC), (Charles W. Smithson), (OIC Education), (OCC)
An option is a financial contract in which the holder has the right, but not the obligation, to either buy or sell a specified quantity of an underlying asset at a fixed price.
These are some of the features and nomenclature of options:
The price at which an underlying asset can be bought or sold is the strike price or exercise price.
The underlying asset.
Options are available on: equities, equity indices, interest rates (or bonds), foreign-exchange rates, commodities, ETFs and futures. This article focuses on equity options.
A contract with the right to buy an underlying asset is a call option.
A contract with the right to sell an underlying asset is a put option.
The contracting parties.
The option contract has two parties: The party purchasing the right to buy or sell an underlying asset is the option buyer or the option holder. The party granting that right is referred to as the option seller or the option writer or the option maker.
An option premium is the amount paid in full by the buyer to the seller for the right conveyed to buy or sell an underlying asset. The premium is nonrefundable.
Every option has an expiration date or maturity date, if an option is not exercised prior to or on its expiration date the contract extinguishes.
American style. When an option can be exercised on any working day prior to the expiration date is called an American option. All equity options traded in U.S. exchanges are American style. The expiration date for a listed equity option; barring Weeklys, Quarterlys and LEAPS; is the Saturday following the third Friday of the expiration month.
European style. When an option can be exercised only during a specified period is referred to as a European option. So far, Standardized European options are exercisable only on the expiration date.
Contract size or unit of trading. The contract size indicates the amount of the underlying interest subject to being bought or sold upon the execution of a single option contract. The contract size for most equity options is 100 shares.
Options Payoff. (Charles W. Smithson), (OCC) Option holding and writing comprises undertaking big risks, but it also carries the potential for profits. The following four diagrams, with their accompanying text, illustrate the four basic instances of equity option investing.
Buying a call option. The holder of a call option pays a premium (Pr) for the right to buy a predetermined amount of shares. When the price of the underlying equity (s) is less than or equal to the strike price (x), the option has no value for the buyer, if this status does not change at the expiration date, the contract ceases to exist and the holder looses the premium (i.e. ROI=-100%). In contrast, if the price of the interest(s) is greater than the strike price (x), the gross profit (GP) is calculated as: GP=s-x. See figure 1.
Selling a call option. When a party writes a call option, it receives a premium (Pr) for the right conveyed to the buyer. As long as the price of the share (s) is less than or equal to the strike price (x) the option seller will keep the premium as a gross profit. However, if the share price (s) is greater than the strike price (x), things start to get gloomy, in this case the gross profit (GP) is calculated as: GP= Pr-(s-x). See figure 2.
Buying a put option. After paying for a premium (Pr), the buyer of a put equity option owns the right to sell an agreed amount of shares at a fixed price. As far as the share price (s) remains greater than or equal to the strike price (x) the return for the holder equals -100%. If the price of the share (s) is less than the strike price (x), the gross profit (GP) is calculated as follows: GP= x-s. See Figure 3.
Selling a put option. As long as the share price is greater than or equal to the strike price (x), the writer of a put option will enjoy a gross payoff equivalent to the premium (Pr), if the share price (s) is less than the strike price, the Gross Profit (GP) for the seller follows the following formula: GP= Pr-(x-s) with the potential for big loses. See figure 4.
A note on option strategies. Option strategies are beyond the scope of this article, suffice it to say that these strategies might involve the purchase of calls at different strike prices and or the purchase of puts at different strike prices and or writing calls at different strike prices and or writing puts at different strike prices. These strategies could also consist of: combining options with forwards and combining options with swaps. Once again, the reader is urged to fully understand options and the risks encompassed in option trading before even thinking about participating in option markets.
Investment objectives. There are three main objectives for a value investor to participate in option markets:
1. Hedging. Options can be a way to protect a portfolio, especially when a savvy fund manager, is able to spot rough seas in the offing.
A value investor using options as hedging. Anthony Bolton is a legendary investment fund manager, he ran the Fidelity UK Special Situations Fund from December, 1979 to December, 2007. The data available (Davis) shows that from December 1979 to December 2005 the annual compounded rate of return for the fund was 20.4% versus 13.8% for the FTSE All-Share Index. He ceased managing funds in 2008, but remained working for Fidelity UK. After announcing his return to fund management, he moved to Hong Kong in April, 2010, to run the newly created Fidelity China Special Situations Plc. In a video interview with Bloomberg, Anthony Bolton said that about 18 months before handing over the Special Situations Fund, managers in the UK were allowed to protect their funds through hedging. Mr. Bolton had some misgivings about the general economic situation. Thus, he took out protection by buying put options which at the time were cheap because markets were strong. Mr. Bolton liked the idea because the operation was like paying for insurance.
2. Leveraging a position. Let us assume that a hypothetical listed call has a $3 quotation and a strike price of $55, the stock from which the call derives (XYZ Company) is trading at $50 per share. By paying $300 ($3 times 100 shares) the call holder has the right to buy the equivalent of 100 shares at $55 ($5,500). If prior to the call expiration, the buyer exercises the call at $100 per share, her gross profit would be: $10,000 ($100 times 100 shares) minus $5,500 ($55 times 100 shares) minus $300 (the premium paid) which equals $4,200.
· Initial investment $300.
· Total strike price $5,500 18.3 times leverage
· Stocks purchase value $10,000 33.3 times leverage
A value investor buys calls to leverage profits and limit losses. Joel Greenblatt (a featured Guru) depicts an instance in which he purchased LEAPS as a means to pursue his investments objectives (Greenblatt). LEAPS (Long term Equity AnticiPation Securities) are options, calls and puts, that can be purchased up to three years before they expire.
In December, 1992 an article brought Wells Fargo (a California based bank) to Greenblatt’s attention. California was in the middle of a deep real estate recession. After giving some thought to the opportunity he concluded:
On the positive side:
· Wells had taken a loss provision of $27 per share in 1991.
· In the first nine months of 1992 the bank added an additional $18 per share provision.
· Notwithstanding the $27 per share loss provision in 1991, Wells had travailed to earn a small profit.
· The nonperforming loans, approximately 6 percent of Well’s total loans, were still yielding 6.2 percent. The prime rate was 6 percent and the rate paid to Wells’ customers was around 3 percent.
· Over the years, Well Fargo’s (NYSE:WFC) management had demonstrated an ability to earn large returns.
· Greenblatt estimated that after the recession, the normalized after tax earnings could be around $18 per share. A valuation between 9 and 10 times earnings per share would imply a price of $160 - $180 per share. Wells Fargo was trading at around $77 per share. So, it was a potential double.
On the negative side:
· Wells had the largest concentration of commercial real estate loans of any bank in California, about $249 per share. BankAmerica’s concentration was $48 per share.
· The balance sheet only gives an idea about the bank loans. You never really know exactly what makes up its loan portfolio. Hence, it is hard to estimate nonperforming loans in the near future.
· The recession could deepen with ominous consequences for the shareholders.
At the time, December, 1992, call LEAPS on Wells Fargo were available under the following conditions:
· Premium $14.
· Strike price $80.
· Expiration date: January, 1995. More than two years ahead.
Joel Greenblatt considered that two years was long enough to learn whether Wells Fargo would survive. He was excited about the upside prospects for the bank. Still, he remained apprehensive about buying the stock. LEAPS on the bank would limit the fund losses at $14 per share while keeping the potential for high returns. In Greenblatt’s view, LEAPS made more sense than stocks.
What happened? Wells Fargo earned almost $14 per share in 1994 and over $20 per share in 1995. By September, 1994; the stock was trading around $160 per share. The book does not state the average exercise price for the LEAPS. If a $160 per share price is assumed, the gross return for this investment was:
Premium= $14 per share.
Strike price= $80 per share.
Gross investment=$94 per share.
Selling price= $160.
Gross return= 70.2%
3. Income. To write an option, the seller assesses that the probability of obtaining a positive return meets her investment criteria and should commit herself to efficiently employ the cash. If uncovered, this strategy may backfire and the premium could seem a paltry amount compared with the sum the investor would be liable for.
A value investor sells derivatives. The following lines describe how Warren Buffett has written some derivatives (not necessarily options) on behalf of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), with the apparent objective to charge a premium and then invest it at Berkshire’s cost of capital. Please notice how Mr. Buffett has eschewed most contracts that require Berkshire to accept margin calls. (W. Buffett).
As of February, 2011, Berkshire Hathaway had 203 derivative contracts open, all of which Warren Buffett is personally responsible for, Berkshire approaches derivatives transactions the same way they analyze insurance deals, these contracts fall into two categories:
The first category consists of bond default derivatives for companies included in certain high yield indices, most contracts have a five year life and cover 100 companies, the premiums received amount to $3.4 billion and the derivatives were written during the 2004-2008 period. In the financial panic of 2008-2009, some of the companies in these indices failed and required Berkshire to pay $2.5 billion. Most of the higher-risk contracts have expired.
The second category of derivatives is equity puts which protect the buyer against a possible decline in equity prices. Berkshire wrote puts for equities in the U.S., UK, Continental Europe and Japan. The contracts are tied to several equity indices like the S&P 500 and the FTSE 100. In the 2004-2008 period, Berkshire signed 47 contracts, most of which run for 15 years and received $4.8 billion of premiums. Only the indices level at the expiration date counts. Berkshire is not obliged to any payment before then (this is a very important feature and shows Buffett´s investment prowess and bargaining power). At the end of 2010, 39 equity put contracts are still active, for which Berkshire charged $4.2 billion. These contracts expire from 2018 to 2026, if the prices of the relevant indices remain the same as they were at the end of 2010, Berkshire would be required to disburse $3.8 billion.
Conclusions. Options or option like transactions have been around for many centuries, but it was not until de 1970’s that options were fully standardized and dedicated exchanges created. The trading volume exploded.
A value investor can make use of options for three objectives: hedging, leveraging a position and income.
Options can be are very risky proposition, no one should consider investing in options until she fully understands options and their risks.
Disclaimer. All the information and research on this article are for informational purposes only. If any reader decides to trade in options agrees to do it at solely (his/her) own risk. None of the material presented here should be interpreted as a recommendation or solicitation to buy and or sale any security. You agree to assume full responsibility for any and all gains and losses, financial, emotional or otherwise, experienced, suffered or incurred by the reader.
References and bibliography.
Buffett, Warren E. "Letter to Berkshire Hathaway Shareholders." 2002. 14.
Buffett, Warren. "www.berkshirehathaway.com." 26 February 2011. May 2011.
CBOE. "Chicago Board Options Exchange." 2011. 2011.
Charles W. Smithson, Clifford W. Smith, Jr, D. Skyes Wilford. Managing Financial Risk:A Guide to Derivative Products, Financial Engineering and Value Maximization. Revised Edition. Richard D. Irwin, Inc., 1995. 288-310.
Davis, Anthony Bolton & Jonathan. «Investing with Anthony Bolton. The anatomy of a stock market winner.2nd Edition Revised and updated.» Petersfield, Hampshire, Great Britain: Harriman House Ltd, 2006. 147.
Greenblatt, Joel. You Can Be a Stock Market Genius. Uncover the Secret Hiding Places of Stock Markets Profits. New York, NY: Fireside, 1999. 213-228.
Nobel Prize. "Nobelprize.org." 14 10 1997. 2011
OCC. "Options Clearing Corporation." 2011. 2011.
—. "optionsclearing.com." 1997-2010. Characteristics and Risks of Standarized Options. 2011.
OIC Education. OIC Education. 2011. 2011.
Ruffy, Frederic. "optionetics.com." 2 12 2002. 2011.
Stocks Options Trading. «Options History. Stocks Option Trading.» 2011. Stocks Option Trading. 2011.
stocks-options-trading.com. "stocks-options-trading.com." 2011.