Last week, I received an email from True Options Masters reader Joseph C about options. I appreciated his question and wanted to share a detailed answer with you.
The question was:
“In more than a few of his newsletters, Michael Carr suggested buying puts on certain stocks and ETFs (exchange-traded funds) as a hedge against market downturns. But don’t you need to own shares on a stock or ETF before you can buy puts on it?”
To answer your question, Joseph — no, you do not need to own any shares of stock before you purchase a put option. I’ll explain further in just a moment.
But first, let me say how much I appreciate this question.
It reminded me that options aren’t well understood by most everyday investors. That’s partly due to many financial planners telling clients they are speculative and risky. They discourage options.
Of course, this isn’t actually to protect their clients. It’s to protect the status quo: the fees they collect for doing nothing.
I’ve never heard a planner say: “I don’t recommend options because the most important thing to me is to protect your assets so I can collect a steady 2% annual fee. Generating great returns isn’t a priority for me. I have bills to pay and I need to keep your assets right where they are.” That would be the honest way of putting it.
You see, the math of being a planner says that it is better to hold the account at its present value rather than actually manage the account to generate gains. That’s because the cost of client acquisition and other behind-the-scenes factors is a higher priority.
Think of it like this…
The last thing a heroin dealer wants is for their client to stop using heroin. The client wouldn’t need their dealer anymore, and the dealer couldn’t take a fee for keeping his client stuck in the same state of being.
Similarly, the last thing a financial planner wants is for their client to learn about any investment strategy outside of passive index investing. They wouldn’t need their planner anymore…
Okay, I’m done lamenting financial planners — for now.
With that off my chest, I want to turn to some options fundamentals that will unshackle the everyday investor from subpar returns.
How Options Work — and Outperform — With Limited Risk
Options generally offer large potential gains with limited risk. I used the word “generally” because options offer an incredible amount of flexibility.
There are dozens of strategies. Some offer low returns and high risk, but they are attractive to specialized traders in the market. Others offer substantial returns with pre-determined risk. It all depends on what strategy you use.
As individuals, we want to focus on just a few strategies that offer reasonable levels of risk, and market-beating returns.
But let’s start by defining what an option is…
An option contract controls 100 shares of a stock or ETF. They all have an expiration date and an exercise price.
The expiration date is the date the contract ceases to exist. This is different than stocks since stocks never expire. The exercise price is the level where the buyer’s rights have value.
There are two types of options — calls and puts.
Calls are contracts that give the buyer the right to “call” for the shares to be delivered (in other words, buy them).
For example, let’s say we buy a call option on Apple with an exercise price of $150 and an expiration date of August 20. This option costs about $4. It gives the holder the right to buy Apple for $150 per share before August 20.
If Apple trades at $155 before the expiration date, the call option will be worth at least $5. That’s because the buyer can exercise the option at $150 and immediately sell the shares at $155. Fortunately, they don’t have to do that. They can sell the call option to realize that profit.
Puts are similar. They give buyers the right to “put” (sell) shares at the exercise price before the expiration date.
Let’s say we buy a put option on Apple with an exercise price of $150 and an expiration date of August 20. That option also costs about $4.
If Apple trades at $145, this option delivers a profit of $1 (the difference between the strike price and the stock price, minus the cost of the option). We could then buy 100 shares of Apple at $145 and then exercise the option to sell them at $145. Again, we don’t have to do that. We can just sell the option.
Put options offer a way to benefit from a market decline. You can do that by buying a put option on a stock or ETF you expect to decline. If the decline occurs, you profit. If not, you can never lose more than the amount you paid to enter the position.
Because risk is limited, this might be the only way an individual investor should trade a potential decline. Thus, it’s the only rational way for an investor to protect their portfolio from downside. That’s something your financial planner will never tell you.
Selling shares short, on the other hand, has unlimited risk. Many funds and large traders have gone bankrupt with this strategy.
Put options offer the benefits of shorting a stock … without the high risk.
But that’s far from their only benefit…
The Income Possibilities of Put Options
Now, remember how I said options are flexible?
I say that because there are two sides to every option trade — a buyer and a seller.
We can buy puts to benefit from price declines. But we can also do the opposite: selling a put that we don’t own to benefit from a price rise.
When you’re on the sell side of the transaction, you earn the premium that the buyer pays. This creates income, which you keep if the underlying stock stays above the strike price of the put option.
So if you’re bullish on a stock and sell put options on it, you don’t even need the stock to move higher. You just need it to stay the same, or it can even fall a little bit, for it to generate income for you.
This is a more complex options strategy, of course. It also happens to be one that your editor Chad Shoop does very well. So well, in fact, that Chad’s win rate with this strategy is 92%.
Puts can also be used in spreads, strangles and straddles. All those strategies have limited risk, and are each appropriate at different times and in different situations.
In True Options Masters, we’ve recommended straddles and discussed spreads in the past. We might use those strategies in the future, depending on market conditions. And when we do, we’ll be sure to walk you through the mechanics of each.
That will include information on how to enter and exit the trade, the potential rewards and the possible risks.
Options are a wonderful tool. They’re something that most everyday investors sadly have no understanding of. So I look forward to helping you understand and benefit from them in these pages.
Michael Carr, CMT, CFTe
Editor, One Trade
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Chart of the Day:
Bitcoin Bulls, You Have Your
Work Cut out for You
By Mike Merson, Managing Editor, True Options Masters
(Click here to view larger image.)
Bitcoin is in trouble… And bulls only have until 9 p.m. ET Sunday to save it.
On the weekly chart, bitcoin has broken through a well-tested support area around $32K. And thanks to its rapid run in December 2020 after breaking its previous all-time high, it doesn’t have any real strong support between here and that level.
Easy come, easy go…
Not all hope is lost, though. Bitcoin has breached this support level several times now, only to close the week above it. And in my view, that’s exactly what has to happen here if a bull run revival in 2021 is likely.
But if bitcoin closes the week below the $32K level … look out below. It stands to fall as much as 40% from these levels.
If you’re a long-term bitcoin investor, I wouldn’t suggest buying any more unless it closes this week strong. Otherwise, wait to see if bitcoin finds a floor above $20K in the coming weeks.
You might be thinking: “Why are we talking about bitcoin? Isn’t this True Options Masters?”
But there are ways to play this move with options, too…
Some bitcoin-heavy, publicly traded companies such as MicroStrategy Incorporated (NYSE: MSTR) and Marathon Digital Holdings Inc (NASDAQ: MARA) are optionable. And they’re highly vulnerable to falling bitcoin prices.
As Mike showed you today, buying puts on these companies could provide hefty returns in the coming weeks — should bitcoin close this week below this key level.
Managing Editor, True Options Masters