This is part of a series of posts for an online class on how to use your investments to fund your retirement. To find other posts in the series, select the category “Retirement Investment Class” under “Retirement Investing” at the top. The posts will appear in reverse order, with the newest post first.
Today’s topic is a bit advanced, so I’ll begin by boiling the lesson down to the key points, then elaborate for those who want to know the details. The key things you need to know about buy-write funds are:
- They can generate a good amount of cash income regardless of current interest rates (with option writing, you can basically turn any stock into a dividend-paying stock).
- They are more volatile than bond funds but less volatile than stock funds.
- They won’t go up as fast as stock funds, but also won’t go down as much.
- You have the potential to make on the order of 25% per year from buy-write funds, but you will rarely do this.
- They will perform the best of anything when markets are stagnant.
So there’s the minimal you need to know. For those who want more explanation, please read on.
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What are call and put options?
You have probably heard the term, “stock options,” when hearing about a CEO who made a fortune because he received stock options from the company. An option is a legal contract between two people. This contract allows one person, the option buyer, 1) to purchase (or sell) 2) a fixed number of shares 3)at a specified price, 4) before a specified date. An option to purchase is called a call option, where the option to sell is called a put option. It is called an option because the purchase or sale is optional, purely at the discretion of the option buyer. The option buyer would buy (or sell) shares from (to) the option seller, also known as the option writer.
Option writers can be covered, meaning they own the shares in the case of a call or have the cash in the case of a put, or naked, meaning they don’t. A naked option writer hopes that the person who holds the contract never executes it, otherwise he’d need to somehow go out and buy the shares at whatever price they were trading so that he could turn around and sell them to the option buyer (in the case of a put, he’d need to find the cash to buy the shares at the specified price, regardless of where they were selling for now). As you can imagine, being a naked option writer is insanely stupid and a great way to lose lots of money. Really, it was naked option writers (who didn’t know they were naked because they bought offsetting options from other naked option writers) who caused the housing market crash in 2008 to almost take out several US financial firms.
To make things easy, most option contracts are standardized, meaning they all are for the same number of shares (typically 100 per contract), have regularly spaced prices at which the shares are bought or sold (called the strike price), and all expire in monthly groups on the same date (the date at which the contract expires is called the expiration date). For example, this month all of the options expire on Friday, March 16th.
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Why would someone buy options?
Options were originally meant as little insurance policies, whether letting someone buy or sell a stock at a certain price. They have become much more popular as speculating tools, however, since they provide something called leverage, which is when you use a little money to control a lot of money. Most readers are probably most familiar with leverage when it comes to home buying, where you can put $10,000 down on a $500,000 house. If the home price goes up 1o% over the next year, you could then sell it for $550,000, making $50,000, or 500% profit. This is really good for a one-year speculation. If you had put down the full $500,000 for the home, you would have still made $50,000, but now it would have only been a 10% profit. Leverage magnifies potential gains.
Options do the same thing. You might buy a set of 10 calls on a $100 stock for $500, meaning that with $500 you now control $10,000 worth of stock. If the stock goes up $10 per share to $110, you might be able to execute the options and sell the stock, making a quick $1000, or 100% profit. (You might also be able to just sell the options to someone else for $1000 since the price of the options would go up when the stock price went up.) If you had bought the shares for $10,000 instead of buying options, you would have only made a 10% profit, plus you would need to find the $10,000 somewhere to buy the stock. This is why people use options, the potential to make a fast profit without putting too much money down. This potential return comes with great risk, however, since your options expire worthless on the expiration date if you don’t use them. You therefore need to be right about both the direction and the timing.
What about writing options?
The person on the other side of the trade described above, the option writer, would get money from the option buyer called a premium. The premium in the example above was the $500 the option buyer paid for the calls, which went to the option writer. The value of the premium varies constantly, based upon the price of the stock relative to the strike price, how volatile the stock is, and how long it is until the expiration date. Basically it is whatever the person who is writing the option is willing to accept from the person buying it at any given time. While the option buyer has the potential to make a lot of money, most of the time he doesn’t. Some thing like 9 out of 10 options expire worthless, meaning the option writer pockets the premium and the buyer limps away with nothing.
For this reason, while the potential profit is less, it is still better to be the option writer because the odds are so much on your side. You might only collect $800 when you write a set of calls on $20,000 worth of stock you own, but if you can do that six times a year, that’s $4800 per year, or a 24% return. Compare that with the historical 10-15% return you can get from buying and holding stocks, and you can see why it is attractive. It is like being able to make any stock into a dividend-paying stock.
Writing covered calls is not without risk. If the price of the stock drops, you will lose money, or at least need to wait for the price of the stock to recover, which could take weeks, months, or years (or never). You are also setting a limit on your potential return. If you have shares of XYZ stock, selling at $95 per share, and you write calls with a strike price of $100, once the stock passes $100 per share you will no longer be making any more money. Also, because there will be some positions where the stock declines in price and times when you just can’t get a good price when writing a new option, it is unlikely that you’ll actually get 25% returns. In actuality, I’d say that you would be more likely to make 8-12% per year, but still it is a good return , especially when dividends are like they are today, at 2% or lower. It is putting cash into your retirement account, so you’ll have cash-flow that you can use without needing to sell stocks to raise cash.
Is there an easier way than writing calls yourself?
Yes. There are mutual fund companies that create buy-write portfolios for you. For example, PowerShares has an S&P 500 buy-write ETF that is like an S&P 500 fund with a call option written against the portfolio. You won’t do as well in this fund if markets are going up as you would be by just buying an S&P 500 fund, but you’ll be doing a lot better if markets are stagnant and a little better if they are dropping. In both cases, you’ll be making 8-12% in premiums to offset whatever the underlying index is doing. For example, in 2017 the fund provided about 11% in cash payments. This is not as good as the 20% percent return you would have had if you were just invested in an S&P 500 index fund, but would provide the cash needed for living expenses.
Note that the price of the buy-write fund will change, meaning that your total return will probably not be 10-12% each year even though you were receiving payments of 10-12% per year. For example, if you receive a 10% payment but the share price drops by 8%, your total return would only be 2%. With income investment, however, you should be focused on the cash return you are getting and not the share price. The fund price may go up or down, but all you need it for the fund to continue providing you the income you need each year. In many ways this is similar to a rental property, where home prices may change constantly in an active market, but unless you are trying to sell the property, all you care about is getting good tenants in and seeing a steady rent check each month that increases over time.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.