Options: They're Not for the Birds

Posted By: Advisor Analyzer Team

At one point in life, we’ve all heard “don’t count your chickens before they’re hatched” and “a bird in hand is worth two in a bush”. Upon hearing these statements, one can deduce two things: first, ornithologists were apparently very influential in the world of idioms at one time. Second and more pertinent to this article, speculation and risk taking has traditionally been regarded as foolish and inadvisable.

 

But should investors unequivocally apply these truisms in the world of finance? Are there situations where one can manipulate the odds in their favor? In this article we’ll show how options can help reduce market risk exposure while still letting you participate in price appreciation. Although “birds of a feather flock together” it should be noted “what’s good for the gander is not always good for the goose”. Ok enough with the fine feathered idioms.

 

Let’s examine why we shouldn’t count our chickens before they hatch. The purpose of the adage is to avoid potential disappointments and costly mistakes by speculating on future events before they happen. A farmer with a dozen eggs should not prematurely expect to sell twelve chickens until after all twelve eggs hatch. Although, the advice seems prudent, in a world of options and guarantees, its pertinence is questionable. Allow me to elaborate.

Without Options:

When investors experience gains in a stock, they believe they have two choices: sell or hold. There are compelling reasons for both obviously: to avoid losing money, or make more of it. Of course, the stock market is a fickle creature and we’ve all sold something to watch it go higher or didn’t sell soon enough. Basically, we were counting chickens only to end up with broken egg shells.

Simple Example on Options:

However, knowledge of options can be a very powerful tool. It essentially hedges your bet for a fee. With options, investors can lock in their profits, while still participating on the upside of a stock. Suppose you had a gain of $10 on a $100 stock. Earnings will be released for this company in a week and you feel it can make a large $20 move up (to $120) or down ($80) depending on the results. Holding on to your stock and praying for the best is one option, selling the stock and never looking back is another.

 

However, purchasing a put option is the most flexible way to lock in a portion of your profits while allowing you to participate on the upside. Suppose you purchase a put option for $1 with a strike price of 100. That means if the stock were to decline to 80, you would receive 20 dollars on the put option. If the stock were to end at 100 or more by maturity, your put option is worthless and you just lost $1. Pretty simple so far isn’t it? Now, when you combine the gain loss profile of the option and stock the net returns are as follows:

Scenario 1: Good Earnings (Stock = $120)

The stock is now at $120 a share due to a record quarter and more good news to come.  Your option is worth nothing, since a put option increases in value as a stock declines.  However, your stock position has appreciated another $20.  The net benefit for holding both the put option and stock is another $19 (= $20 gain from the stock less the $1 paid for the put option.  Not bad if you ask me.

Scenario 2: Bad Earnings (Stock = $80)

Suppose the company announced a horrible quarter and the losses are expected to continue in the near future. The stock commences to plummet to $80, creating a loss of $20.  However, you purchased a put option as insurance for a dollar remember?  The put option is now worth $20.  Since you paid $1 for the right to sell the stock at $100 (strike price), your gain from the put option is $19 dollars.  When combined with the stock position, your net loss is only $1, the amount paid for the put.

Conclusion:

When all is said and done, by paying the $1 premium, you are able to increase your returns relative to the amount of risk taken.  A downside of $1, with an upside of $20 (or theoretically infinity) is not a bad investment proposal, especially given the fact the put was purchased with previous gains.  Options are a great way to lock in your profits, while not forgoing the opportunity to experience further price appreciation.  It’s as if you have a friend to hold your bird in hand, so you can try to grab those two in the bush.  All your friend asks in return is an egg that he hopes will one day become a chicken.