Some thoughts on derivatives – Options

Some thoughts on derivatives – Options

These are legitimate arguments, however a more detailed analysis of the idiosyncrasies of each type of derivative and, more deeply, of each strategy, provides us with a less gloomy and more pragmatic view of these instruments. A great example are the options (calls and puts), in particular those that have stocks as an underlying instrument. There is a plethora of these derivatives on the market, but a great chunk of the open positions is directional betting, only intended to hit a right movement (high or low), so once the position is settled, a new bet is opened. Because they are strictly speculative operations, they not only involve a higher level of risk, but also demand a more elaborate management and monitoring.

However, using options, together with stocks, can work as a powerful instrument for reducing the risk of any portfolio. The secret here is the expression “together with stocks,” for it is at this point that we put aside the idea of easy, quick, and sometimes irresponsible profit. By embracing the idea that options can serve a purpose other than an end in themselves, pure and simple speculation becomes risk-minimizing or leveraging additional gains. Therefore, the fundamental premise to operate this type of approach is having the stocks composition chosen from a very careful evaluation, regardless of the opportunities associated with options. The inversion of this rational is quite common – stocks bought from the available series of options, completely disfiguring the original logic of complementarity.

A particular and widespread case of the marriage between stock and option is the covered call targeting its exercise, selling deep in-the-money strikes. In this specific case, the search is for the fixed return of the married transaction, whether or not the underlying stock is worth. Although this may sound contradictory, this type of strategy carries considerable risks because it bets exclusively on the stock price – in the event of a downturn, the investor remains with a stock that many times would never have bought alone.

Setting the premise above and once selected the list of stocks after strong analysis – qualitative and/or quantitative – it may give rise to opportunity on its associated options. Two types of strategies could be easily implemented, producing benefits often overlooked by the recurring investor. The first is similar to the “fixed return” strategy mentioned in the previous paragraph. However, two details make the risk, potential of return, and goal completely different. When chasing a quick “fixed return” the option strike will always be the lowest possible value, or “deep in the money”. The chosen stock for the “fixed return” usually shows high volatility and does not comprise the requirements for participation in the investor’s portfolio.

The trade is targeting the sole purpose of extracting a known and timely gain, usually within a short period of one or two months. Although valuable, this type of strategy, if poorly implemented, subjects the investor to substantial market risks. On the other hand, by selling a call with a strike well above the market price (“out of money”) the investor will periodically have access to the premium value, keeping his stock in the portfolio. It works as an additional value to the income from the dividends and the embedded capital gain contained in the portfolio.

The second strategy to add value to the stocks portfolio is selling puts as an alternative to the purchase of the stock. Despite being a directional trade, it is essential to make a distinction. A pure and simple short put only seeks the income of the premium, betting in the appreciation of the stock. On the other hand, when selling the put with a strike consistent with the price that would be paid when purchasing the stock, two situations may happen – the stock price may rise above the strike, providing a gain from the premium received, or may fall below the strike, which would carry out the buy exercise.

In such situation the investor actually starts the position bought in the stock on a price below the price which would have been paid if it were simply to buy in the market, due to the premium received by the prior sale of the put – a benefit that can reduce the cost price considerably.


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