A World Without Options

Posted By: Advisor Analyzer Team

Imagine a world without options: vanilla is the sole flavor available at your local ice cream parlor, restaurants only offer soup (discouraging salad lovers everywhere) and blinking is as effective as changing channels to see what else is on.  Options are an essential element to freedom and what make the world a more interesting place.  It’s the freedom to choose what best fits our individual taste; a word describing privilege and luxury.  So why does such a beautiful truism unduly grow horns and pointy tail when coupled with the word “stock”?  The time has come to exonerate calls and puts from their notorious reputation as portfolio taboo: it’s time we exorcise options.

 

Without much detail on the mechanics, there are essentially two types of options; calls and puts.  Call options appreciate as the underlying stock price rises, and put options behave diametrically by depreciating.  Both calls and puts have predetermined strike prices and expiration dates that dictate their intrinsic values and time premiums.  When viewed individually, the technical aspects of options are fairly black and white.  However, once aggregated with other securities, options can cost effectively replicate a multitude of portfolio outcomes and market exposures.

 

To demonstrate, let’s examine the Dow Jones Industrial Average (DJIA) for August 27, 2008.  The Dow closed at 11,502.51 up 89.64 for the day.  Since the Diamonds Trust Series 1 (DIA) is the Exchange Traded Fund (ETF) tracking the Dow, we’ll also view DIA which closed at 115.00.

 

8/27/08	Day's Close	Day's Move	Open	Daily High	Daily Low
Diamonds (DIA)	115.00	(-.93)	114.24	115.59	113.84

 

The Dow is a price weighted index of 30 NYSE and NASDAQ stocks including Microsoft (MSFT), Johnson and Johnson (JNJ), Exxon Mobil (XOM) to name a few. Each stock’s price change proportionately affects the Dow’s movement by their concurrent weights. Below are the companies included in the Dow Jones Index.

 

Company	Price	Company	Price	Company	Price
3M	70.72	Chevron	86.62	Alcoa	32.08
Citigroup	18.12	AIG	20.00	Coca-Cola	53.79
American Express	38.82	Dupont	44.34	BAC	29.65
Boeing	64.52	GM	10.20	Caterpillar	69.56
Home Depot	27.17	Microsoft	27.56	IBM	123.38
Pfizer	19.08	Intel	23.41	P & G	70.06
Johnson & Johnson	71.21	United Tech	65.05	JPM Chase	37.14
Verizon	34.71	McDonalds	62.08	Wal-Mart	59.29
Merck and Co.	35.73	Disney	31.76

 

Suppose you would like your portfolio to mirror the Dow for the coming month. There are several ways this can be achieved, the easiest being proportionately purchase the 30 stocks that comprise the Dow. However, buying and consequently selling 30 stocks for a month’s market exposure may be least efficient once transaction costs are considered. Say the Dow remains flat that month; the cost to buy and sell 30 stocks would most likely leave you in the red (since you pay for 30 X 2 = 60 transactions).

 

Assuming ETF’s are without tracking error, the Diamonds fund (DIA), provides the desired market exposure but more efficiently. Here, 60 transactions are whittled to two: the purchase of DIA, and the subsequent sale in a month’s time. Assuming only cash positions, the cost to purchase 100 shares of Diamonds is $11,500.00 before commissions. While more cost effective than the outright purchase and sale of 30 stocks, some may find $11,500 to be less affordable if it’s a substantial portion of one’s portfolio.

 

But what options are available aside from the above mentioned? The answer is (quite deliberately) embedded in the question. Suppose an individual would like to purchase 100 DIA shares, but faces a capital shortage in their portfolio. Through options transactions (or just derivatives as a whole), one can synthetically obtain identical market exposure for a fraction of the required capital.  Before making that call to the Securities Exchange Commission, allow me to elaborate.

 

Call	Price	Move	Volume	Open Interest	Strike
DIAK.X	2.15	.36	10,057	14,973	115.00

 

Put	Price	Move	Volume	Open Interest	Strike
DIAUK.X	2.15	-.55	9740	17799	115.00

 

Listed above are the September calls and puts with 115 strikes. DIA closed at the money (115.00) and both calls and puts are equally priced. To synthetically gain market exposure the strategy is to long (buy) 1 call contract, and short (sell) 1 put contract, with each contract representing 100 DIA shares. For simplicity, assume the bid ask spreads for both positions are negligible, effectively creating a zero cost collar. Once entering both long and short positions, notice the cost to purchase the calls (-$215.00) are offset by the funds received from the put sale (+$215.00) making our initial cost zero.

Assume DIA closes at 117.00 next month. Had you purchased DIA, the net gain before transaction costs would be:      

 

· $11,700.00 – $11,500.00 = $200.00 profit

 

With the zero cost collar strategy, the puts expire worthless (since they are out of the money) and the 115 calls are:

 

· 117.00 – 115.00 = 2.00 X 100 = $200.00 profit

(Note, we multiply by 100 since 1 options contract = 100 shares)

 

Now suppose DIA closed at 114.00 rather than 117.00. Here, the DIA trade yields: · $11,400.00 - $11,500.00 = -$100.00 Loss

 

With our option strategy, the calls expire worthless, and the 115 puts create a:

 

· 114.00 – 115.00 = -1.00 X 100 = -$100.00 Loss.

(Note, since we are short, not long, the puts, we experience loss for in the money puts)

 

In fact, regardless of market close both DIA and our options trade result in identical profit and loss scenarios. The distinguishing factor (ignoring transaction costs) is the initial amount invested; with DIA being the more capital intensive of the two.

Conclusion:

So why do investors carry pitchforks and torches at the slightest mention of stock options? Maybe it’s from a bad experience in the past or just too much disposable income. Perhaps it stems from a fear of the unknown or an old wives tale passed from generation to generation to keep investors honest. Whatever the reason may be, having and using options can be very effective for obtaining market exposure, or at the very least enjoying three scoops of something other than plain vanilla at your local parlor.