The stock market is irrational at the best of times. It cannot even claim to be a reflection of the economy’s health at this point. The derivative market is three times larger than the value of the world’s financial assets (all stocks, bonds, bank deposits) — showing that the market activity isn’t really that much to do with the actual value of its own assets.
S&P 500 for example has already rallied back after its March crash to the same price as Christmas time last year. Remember Christmas time last year? Black Friday, Cyber Monday, Christmas sales, no Coronavirus, everyone working…
The market doesn’t quite feel right at the moment, and it’s volatile. So, we’re going to explore what options are, and how option trading for hedging may be appropriate in dealing with this 2020 madness.
The rising popularity of Options
Options are often perceived to be a complex investment tool, and one that is used in riskier portfolios. They’re not widely used by retail investors, and they’re often argued to be a zero-sum game.
Buying calls and puts means that your winning percentage is likely going to be around 50%, which is less than most long-term stock investing strategies.
Now, this isn’t strictly true; they don’t have to be complicated nor risky, though there is somewhat of a learning curve. Times are clearly changing though, because there’s been 40% more options trades than this time last year. A new wave of investors on top of a turbulent, volatile market is what’s created this demand for options.
So, what exactly are options?
Options are contracts, and those contracts give the buyer the right (but not the obligation) to buy or sell an underlying asset at a specific price. These are trades for either income, speculation or to hedge against risk. They’re a derivative because their value is derived from an asset, and isn’t the asset itself.
The difference between call and put options is the difference between buying and selling. A call option is a contract giving the buyer the right to buy, whereas the put option contract gives the right to sell the underlying asset at a given price.
They are often used for speculative purposes, to wager on the direction of a stock. This isn’t the best use for them per se, but this strategy can be rewarding. They’re often used to hedge against a declining stock market, but you of course would benefit from this if you had a whole portfolio full of call options with no puts — because you want to be able to have a guaranteed sell price in the event of a market crash. Otherwise, you’re in a situation where the stock market falls by 10% but the calls lose 99%.
Why? Because you don’t actually own the stock, you only owned the right to buy the stock. But the benefits of this is that you’re in a leveraged situation where you can potentially increase your returns, and you can also limit your potential losses.
What does an option look like?
Let’s take a call option for example: You will see a call option quote as having the option type on it (in this case, call), what security it pertains to, it’s expiry, its strike price (what the option holder can purchase) and the premium (a price per share for this option). All options expire on the third Friday of the month listed. The day after this Friday, the option has expired.
Before this though, you don’t even need to exercise the option if you’re “in the money” and the market price is higher than the strike price. Instead, you can simply sell the option contract itself (now you can see the true nature of derivatives).
But if you were “out of the money”, i.e. the price had decreased, then you have no reason to exercise the purchase of these now-overpriced stocks. So, the options expire and you lose all of that premium money.
Should you be looking into using PUT options?
Put options are quite a bit different to call options. There’s one thing speculating on prices to go up and trying to nip in there early by leveraging a call option (that could then go on to become useless), and there’s another using it as a form of hedging (you can think of it like paying a premium for insurance).
In such turbulent times and a truly scary market which is beyond irrational, it should frighten the life out of you knowing that your net worth is tied up in such an absurd market. And if the market doesn’t scare you enough, freak incidents might.
It was only recently that the Solid8 CEO, a San Francisco tech firm, was caught on camera hurling racist abuse to a couple in a restaurant. The company this morning has been obliterated on Google Reviews, and if it was on a public exchange, there would be zero doubts around a price plummet.
In fact, Elon Musk knocked $14 billion off Tesla’s market value in one tweet. This is the kind of world we’re living in, where Hertz have gone up 8 times in value, two days after declaring bankruptcy, whilst you have unstable self-sabotaging CEOs self-immolating their own companies.
So, this brings us to protecting ourselves from a market collapse or your specific stocks from plummeting… Having put options with a guaranteed sell price would be an effective way to protect these losses. Of course, there are two concerns here.
The first is that your put option is redundant and out of the money if the stock continues to rise (which, every stock in this market seems to be rising… Until the next crash at least). Secondly, if you buy a put option too late, the premium will cost too much, making it an expensive way to hedge.
Before using any form of derivative, understand the risks inherent to them. These can be great tools for rounding off a solid portfolio with some hedging, but if used exclusively, their leveraging nature can make them dangerous. Afterall, at least if you buy the stock yourself, time is the best healer in the event of a crash, unless they’re one of the companies that doesn’t survive it — and usually those recoveries are quick.