Authored by William Herrmann

Vega, Rho, Theta, and Delta are terms often used to name fraternities and sororities and likely more familiar to many in that context as opposed to being central in the pricing and trading of derivatives.

If you are currently making use of options and are not familiar with the above important terms, we believe you should not be utilizing options. In our view, which is shared by many, one must be an expert on trading the underlying (in this case equities) prior to even considering trading equity options (options on equities are a derivatives).

Unfortunately, this is not the case, as depicted by the charts below:

Doubling Down on Derivatives Average Daily Options Volumes

In addition, we trust that most current or prospective options traders are not aware of the following:

“90% of retail option traders that trade on margin lose 90% of their funds in 90 Days.”

However, discount brokerages (more often referred to as online trading platforms) portray a different narrative to prospective and existing clients.

For instance, E*TRADE, one of the more popular discount brokers, recently ‘tweeted’ the following:

“If you can figure out how to tackle your kid’s dorm room furniture, you can easily tackle options with E*TRADE. ”

We believe the above is a dangerous statement that is in direct contrast with protecting investors.

Per the Wall Street Journal:

While brokerages can’t recommend certain types of products for self-directed clients, they are allowed to make that kind of investing possible, said Benjamin Edwards, a law professor at the University of Nevada, Las Vegas, who runs a free investor clinic.

“It’s sort of like, you come to Vegas and no one is recommending you drink and gamble, but it’s available,” Mr. Edwards said. He said he has seen more cases lately of investors losing considerable sums on options bets.

Mr. Edwards, the law professor, likens the rising participation in options to the run-up to the tech-bubble bust, when online trading became ubiquitous and brought Wall Street to Main Street. Then, many first-time investors flocked to E*TRADE and other electronic brokers, chasing internet and biotechnology stocks higher until those companies went bust.

“This feels familiar,” he said.

The Use of a Put Option to Protect Value

Your author concedes that using put option as a hedge against shares that one already owns may be a prudent strategy to protect against the decline of an underling equity for retail investors.

Let’s say an investor purchased 100 shares of ABC Company (ABC) stock for $10 per share. The price of the stock increased to $20 giving the investor $10 per share in unrealized gains—unrealized because it has not been sold yet. The investor probably does not want to sell their ABC holdings, because the stock might appreciate further. They also do not want to lose their $10 in unrealized gains. The investor can purchase a put option against the stock to protect a portion of the gains for as long as the option contract is in force.

In practice, the investor would buy a put option with a strike price of $15 for 75 cents (equity options are quoted differently than the price paid for the option, or premium, as noted below), which creates a worst-case scenario (in theory) of selling the stock for $15 per share. If all things remain equal and the put option expires in three months and the stock falls back to $10 or below before option expiration, the investor is protected against any losses below $15. In short, anywhere below $15, the investor is hedged until the option expires (in this case only 3 months). The option premium cost is $75 ($0.75 x 100 shares). As a result, the investor has locked in a minimum profit equal to $425 ($15 strike price – $10 purchase price =$5 – $0.75 premium = $4.25 x 100 shares = $425).

To execute this closing trade, the investor would “exercise” his put option by telling his broker that he wants to sell stock at the $15 strike price. The premium paid for the put is not recovered, but the stock is sold at $15, well above the market price of $10.

To summarize the exercise of the put option, if the stock declined back to the $10 price point, unwinding the position would yield a profit of $4.25 per share, because the investor earned $5 in profit—the $15 strike less $10 initial purchase price—minus the 0.75 cents premium.

If the investor didn’t buy the put option, and the stock fell back to $10, there would be no profit. On the other hand, if the investor bought the put and the stock rose to $30 per share, there would be a $20 gain on the trade. The $20 per share gain would pay the investor $2,000 in profits ($30 – $10 initial purchase x 100 shares = $2000). The investor must then deduct the $75 premium paid for the option and would walk away with a net profit of $1925.

Of course, the investor would also need to consider the commission they paid for the initial order and any charges incurred when they sell their shares. For the cost of the premium, the investor has protected some of the profit from the trade until the option’s expiry while still being able to participate in further price increases.

Investors should always defer to the advice of their registered financial advisor before employing the above strategy, any other investment strategy, or prior to investing into any asset, notwithstanding the use of options as strategy or not.

References:

1. Institute for Trading, May 15, 2017, 2017, https://www.youtube.com/watch?v=L7G0OfJUON8 @30:15
2. Telford, Taylor, and Renae Merle. “Morgan Stanley Buys E-Trade In $13 Billion Shakeup to Brokerage Market”. Washington Post, Feb 20th, 2020, https://www.washingtonpost.com/business/2020/02/20/morgann-stanley-etrade/.
3. Banerji, Lisa. “The Day Traders Are Back, Now Playing with Options”. WSJ, May 11th 2019, https://www.wsj.com/articles/the-day-traders-are-back-now-playing-with-options-11557572401

THE INFORMATION CONTAINED HEREIN REPRESENTS THE AUTHOR’S SUBJECTIVE BELIEF AND IS NOT AND SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE. THE INFORMATION AND OPINIONS PROVIDED HEREIN SHOULD NOT BE TAKEN AS SPECIFIC ADVICE ON THE MERITS OF ANY INVESTMENT DECISION. INVESTORS SHOULD MAKE THEIR OWN DECISIONS REGARDING THE INVESTMENT STRATEGIES MENTIONED HEREIN AND THEIR PROSPECTS BASED ON SUCH INVESTORS’ OWN REVIEW OF PUBLICLY AVAILABLE INFORMATION AND SHOULD NOT RELY ON THE INFORMATION CONTAINED HEREIN. NEITHER THE AUTHOR NOR ANY OF HIS AFFILIATES ACCEPTS ANY LIABILITY WHATSOEVER FOR ANY DIRECT OR CONSEQUENTIAL LOSS HOWSOEVER ARISING, DIRECTLY OR INDIRECTLY, FROM ANY USE OF THE INFORMATION CONTAINED HEREIN.

THIS ARTICLE INCLUDES INFORMATION BASED ON DATA FOUND IN INDEPENDENT INDUSTRY PUBLICATIONS. ALTHOUGH WE BELIEVE THAT THE DATA ARE RELIABLE, WE HAVE NOT SOUGHT, NOR HAVE WE RECEIVED, PERMISSION FROM ANY THIRD-PARTY TO INCLUDE THEIR INFORMATION IN THIS ARTICLE. MANY OF THE STATEMENTS IN THIS ARTICLE REFLECT OUR SUBJECTIVE BELIEF.

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