How To Enhance Returns With Stock Options!

By Dr. Scott Brown

Director of Education

Investment U

Money Management

• Put at least 70% in a portfolio that is well diversified by category.

• This Is Your Portfolio’s “Passive Core”– Gone Fishin’ – Berkshire Hathaway A or B

• Of the 30% left over trade and invest by style:– 80% long newsletter recommendations.– 20% in Stock options (no more than 6% of your total portfolio)

For Instance, $100,000 Goes…

• $70,000 in Gone Fishin’ or Berkshire Hathaway.

• $30,000 into stocks and equity options…– $24,000 long Oxford Club Newsletter stock

recommendations.– $6,000 trading same recommendations with

equity options.

• “Passive Core” keeps you “safe” from yourself!

Why Stock and Options?

• With Stock “Time Is Your Friend!”– But, Potential Returns Are Lower.

• With Options “Time Is Your Enemy!”– But, Potential Returns Are Higher.

• Mixing both can give you higher returns with the same or lower risk.

• But, options require practice and study.

What Is An Option?

• An option is a financial instrument called a “derivative.”

• “Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values.”

---Warren Buffett, 2002 Letter to Berkshire Hathaway Shareholders

Option Components• A contract that give you the right to buy or sell 100 shares of stock.• Contract specifies…

– Whether you can buy underlying stock — called a CALL.– Whether you can sell underlying stock — called a PUT.– The price you can buy or sell at called the STRIKE.– How much the contract costs called the PREMIUM.– The date up to which the contract is valid called the EXPIRATION.– An option is IN-THE-MONEY when it can be exercised for a profit.– An option is OUT-OF-THE-MONEY when it cannot be exercised for a

profit.– You can buy a contract and be LONG the option where premium is

taken out (debited) from your account — you lose only the cost of the option if the contract expires worthless out of the money.

– You can sell a contract and be SHORT the option where premium is collected into (credited) into your account — you lose everything and more if the option goes into the money.

Option sellers are not stupid.

• They charge you more the more time you want your options working for you.

Long The Call Option

• Stops your loss at a certain lower price.

• But only for a certain amount of time.

• The protection costs you money.

Long Option Strategies

• Are known as “buy” strategies.• You are buying the contract.• Have unlimited profit potential with limited

possible loss.• You make money as the underlying stock price

goes…– Above the strike of a call or below the strike of a put.– Known as in the money.– Because you can exercise for a profit!

Short Option Strategies

• Are known as “write” strategies.• You are writing the contract that you sell.• Have unlimited loss potential with limited

possible profit.• You make money as the underlying stock price

goes…– Below the strike of a call or above the strike of a put.– Known as out of the money.– Because the option drops in value or expires

worthless!

Option Margin

• Selling (writing) a naked CALL option means that you have to buy the stock and deliver it to the buyer if he or she exercises.

• If you don’t own the stock already you’d have to buy it if the buyer exercises in-the-money.

• You’d need a lot more money than the premium you collected.

• So brokerage makes you put down cash deposit as collateral so you won’t bug out on the deal.

Option Margin

• Selling (writing) a naked PUT option means that you have to buy the stock from the option buyer if exercised in-the-money.

• You will need a lot more money to buy the stock than the premium you collected.

• Why beginners try to write options and get weird messages like: "You need at least $100,000 in your account in order to write uncovered call/put."

• Long options are no problem because there is no risk to you (or you defaulting on the brokerage) above and beyond the premium you pay for the put or call…you don’t need margin for long equity options!

Combined Option Strategies

• Are known as “buy - write” strategies.• You are buying a contract(s) and selling a

contract(s).• The idea is that the premium collected on the

short option write offsets the cost of the long option buy.

• You can also go short the option and long the underlying stock also known as a covered call.

• You can go long a put and long the stock also known as a protective option.

Option Pricing Factors

• American versus European• Strike Price (X)• Underlying Stock Price (S)• Strike Relative To Underlying Price (High S or

Low S) • Time to Expiration (T-t)• Volatility as measured by the standard deviation

of historical underlying stock price returns(σ2).• Risk Free Interest Rate (r)• Dividends (D)

Increase In A Pricing Factor…Factor Call Put

S ↑ ↓

X ↓ ↑

T-t (little) ↓ ↓

T-t (lots) ↑ ↑

σ2 ↑ ↑

r ↑ ↓

D ↓ ↑

Black-Scholes Pricing Model

• Based on Fundamental Physics Model Of Heat Dissipation – (see Churchill, R. V. Fourier Series and Boundary Value Problems,

2d ed. New York, McGraw hill, 1963).

• Yields Partial Differential Equation Relating All Pricing Factors Using Stochastic Calculus…

02

12

222

rVS

VrS

S

VS

t

V

Pay Attention to the Greeks!

• Option value with respect to the underlying price is known as the "delta" and is given by the first partial derivative with respect to underlying price…

• Option value with respect to the underlying price is called "Gamma"…

• Option value with respect to the time is called "Theta" and is…

• Option value with respect to underlying volatility is called "Vega.” There is no Vega letter in Greek so we use the letter Tau…

• Option value with respect to changes in the risk free interest rate is called "Rho" and is…

S

V

S

V

2

2

S

V

t

V

2

V

r

V

Use Your Real Risk Measures

• Always think about delta, gamma, and theta, and less often about vega.

• The slope of the call value over time (delta) tells you how much you make per $1 change in underlying.

• Gamma (the curvature) tells how delta changes and is directly related to the magnitude of time decay (theta).

Crack’s Three Key Rules

1. Options magnify stock specific risk so try to hold options on at least 3 stocks at once.

2. Only trade with risk capital that you can afford to lose completely very quickly.

3. Be unemotional. Sell when it is time to sell, and buy when it is time to buy. Without hesitation.

-----Prof. Timothy Crack, PhD (MIT)Professor of Finance, Otago University, New Zealand

Crack’s Para-trading Secret

• Buy stock and buy calls.

• When the market has been running up and you expect it to pull back sell the stock.

• Buy the stock back lower and repeat.

• Do this because Transaction costs for options are often 10X that of the stock.

• Perfect strategy for momentum stocks!

A Simple Problem!

Which…

1. Expiration?

2. Strike?

That REALLY is all there is to it!

Setting Expirations

Style Movement Expiration σ Window

Momentum Short Term 3 - 6 Months Prior 6 Months

Hot IPO Short Term 6 - 24 Months Look-back Expiration Length

Takeover Intermediate Term

6 Months Prior 6 Months

Insiders Long Term 6 - 24 Months Look-back Expiration Length

ADR Intermediate Term

6 Months Prior 6 Months

Estimating Strike

• Take Monthly Closing Prices from http://finance.yahoo.com/

Visa (NYSE: V)

Month Close

9-Feb-09 56.71

9-Jan-09 49.35

8-Dec-09 52.45

8-Nov-09 52.56

8-Oct-09 55.35

8-Sep-09 61.39

Estimating Strike

Two Key Rules:

• Out-Of-The Money Rule: Do NOT buy far out of the money options just because they look cheap!

• In-The Money Rule: Do NOT buy far in the money options just because Delta and Gamma are high!

Estimating Strike

• Go 1 Standard Deviation Out on stocks over $10 with normal underlying volatility (between 10% and 60%).

• Take Monthly Price Changes.

•

• is the average Monthly Closing Price, n is the amount of months, xi is each daily Price observation

• For Visa σ = 4.19• With Visa at $50.19 you would focus on a 55 Strike at 6

months out. • MS Excel has STDEV(number1,number2,...)

Best Simple Bullish Trade

• “I often find the option that is the most expensive out of the money call (i.e., only just out of the money) is the best simple bullish trade.”

• “This rule is not sensitive to large volatility numbers (i.e. don’t try this if volatility has been high). “

• “Really need to look at this on a case by case basis” (Using Prof. Crack’s Spreadsheet).”– Timothy Crack in personal email to me.

Estimating Strike

• These are very simple rules.

• If you want to go advanced you need a good option spreadsheet.

• Get Prof. Timothy Crack’s Basic Black Scholes.

• Use the Spreadsheet that comes with it!

Putting It Together

Call Strike Symbol Last Chg Bid Ask Vol OI

Sep 09 55 VIK.X 6.1  1.21 5.8 6.1 59 984

2010 Leap 55 LGBAK.X 7.7  1.60 7.7 8.1 874 16,183

2011 Leap 55 VSKAK.X 11  3.47 11 12.1 3 114

Putting It Together

Pay Attention To Volatility

• “I worry that shorting the market using long puts is dangerous when [implied] volatility is high because if you are long and [implied] volatility drops, you lose quickly even if the market does not move. Not so for an index ETF that is immune to changes in implied volatility.”

-----Prof. Timothy Crack, PhD (MIT)

Professor of Finance, Otago University, New Zealand

Lesson

When implied volatility is high and you expect the general market to drop…

1. Short shares of an ETF.

2. Hedge with a long out-of-money call.

On The Importance Of Volatility

• According to Crack (2004) US stocks priced over $10 per share have an annual historic volatility σ between 10% and 60%. He notes that low-priced stocks can have much higher volatilities than that (SD of 120% to 200% per annum)!– Focus on higher priced stocks for your option

trading!

Focus On Stocks Over $10!

What is Volatility Today?

Price ImpVol Min Max Firms

Under $5 112% 59% 172.7% 31

$5-$10 82% 56% 131.8% 33

Over $10 56% 24% 110.3% 272S&P500 companies close of business 3/17/09.Prof. Crack pulled closing price and 12 month call option implied vol.

Source: Prof. Timothy Crack, PhD (MIT)Professor of Finance, Otago University, New Zealand

Comment

• “These numbers are bigger than they used to be! I expect them to fall over the next 18 months.”

------

Prof. Timothy Crack, PhD (MIT)

Professor of Finance, Otago University, New Zealand

Conclusion

• Be very cautious buying options now in March 2009 ---- long stock (or para-trading) is more preferable.

• High implied volatility means that option prices are very high to account for high future uncertainty.– Think of hurricane insurance. If Florida were hit 3

years in a row you would expect insurers to push prices way up.

– Very high past underlying volatility is currently translating into high implied option volatility!

Option Spreadsheets

• Again, as you get more advanced you should use an option spreadsheet.

Best Book On Options

• Basic Black Scholes: Option Pricing and Trading (new addition in a few months)– Timothy Falcon Crack (Ph.D. Finance, MIT)– Read the Book– Use Professor Crack’s Option Spreadsheet

For Selecting Options If You Want To Do It Right!

– Go to BasicBlackScholes.com for his book