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Option Thoughts

August 23, 2011
Ameya Pandit

Ameya Pandit

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The recent turmoil in the market has created some buying opportunities for the adventurous. This correction has created interesting value opportunities. Further, most of the discussion has been focused on long (or short) ideas, corresponding trades and market opportunities. Derivatives (calls and puts) strategies have not been talked much during this selling frenzy. I am taking this opportunity to talk out some of my thoughts for an option based strategy from a value perspective. The analysis is really qualitative and does not investigate the approaches of pricing options etc. Note here — we aren't going to vulture into LTCM kind of deals, just some simple mental exercises of calls and puts that provide some interesting alternatives. Of course as the saying goes — "there are may ways to Jerusalem" — so we ignore the exotic options and interweaved strategies but focus on something readily accessible to almost everyone (primarily small party investors).

In times of depressed prices, most serious value investors look for companies selling at a discount to what they believe is a judgment of valuation. The intrinsic value (or the gut feel as I call it) is any individual's guess and on a general note varies from an investor to another. The calculation of intrinsic value requires enough investigation to warrant the assumption that the investor is seriously interested in taking a position in the stock. As an example, the long only investor should perform the act of buying when the price falls below his intrinsic value because the act of performing a serious valuation and coming to a conclusion on intrinsic value shows his aforesaid interest. Derivatives, primarily options offer an interesting spectrum. To further understand about taking positions in them, let’s look at the basic combinations for calls and puts from this perspective. I am discussing the definition of these strategies from the viewpoint of an investor who wants to hold (long/short) position in a stock. We are not interested in performing option trading — scope is outside this discussion. The whole point is to take a position in an option so that we can enter a position in the stock. I will talk on the long side of things but the analysis can be applied to short side as well.



Long


Short


Call


Able to buy stock if stock price goes above exercise price


Able to sell stock if the stock price goes above the exercise price


Put


Able to sell stock if the stock price goes below the exercise price


Able to buy stock if the stock prices goes below the exercise price


With the above table as a reference, if I am serious long only investor looking for a value buy, the bet would be to sell a out-of-the-money put with an exercise price closer to the intrinsic value calculated. This bears the assumption that the intrinsic value of the stock is lesser than the current market value. It has to be — otherwise the investor would simply buy it at the current market price.

Buying a call also resembles a way to own a stock. The difference is subtle but noteworthy. In the case of this strategy — call buying — the bet (and the hope) is that the price would rise because the call would lose its value if the price goes below exercise price. Why would you pay for something that is eventually going to lose its shine but still own the stock? In the case of writing a put, if the stock falls below the intrinsic value (or exercise price), the put is assigned and you get to own the stock. Further, you get to keep the premium.

The subtle difference is in a buying a call you pay for owning a stock that you are interested in buying whereas in a selling a put you get the premium so you can buy the stock later, i.e., someone pays you just so that you buy it if it goes below the exercise price. Double win in the case of put writing – Premium + Stock. Since the eventual bet is to own the stock and not to play the option (again this is important – own the stock), buying a call would not make sense because the investor is essentially buying an in-the-money call that is more expensive. He has given up the premium and lost the opportunity in a depressed market to earn good yields. Option writing (insurance) yields in depressed markets are attractive. What better way to own a stock when you are absolutely sure to own it?

The market for options is not available for all stocks, making it less liquid and the universe of available opportunities limited. However, in times of panic the yields are so attractive that put option writing can be very lucrative. One of the stocks I do own in my portfolio MSFT has a interesting price pattern for options I observed today. The January 2012 put for an exercise price of $22.50 is selling at $1.51 per share. In a sense, I am getting $151 for a $2,250 lock on an option contract (1 contract=100 shares) which is equivalent to 6.71% for five months or around 16% annualized) return if MSFT never reaches that price. This is of course before fees but using a low cost brokerage is essentially giving me a comfortable return. Go a little further in expiration, and you can see the yields go up.

Again, the point of this article is not to discuss whether the price of the option is right, but a judgment on how to use the current option prices to see if we can benefit from them. A 6.71% yield for five months is much better than putting that extra money in the bank that you would want to use anyway in buying your stock.

Disclosure

I am long MSFT (Microsoft)

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