Understanding Options

After the?Upticks?episodes?Understanding Stocks?and?Understanding Bonds, Falcon Wealth Advisors?Founder and Wealth Advisor Jake Falcon, CRPC? ,?and I thought it would be useful to talk about another type of investment people may be less familiar with – options.

Options present the opportunity for some investors to potentially grow their wealth—but trading them can be incredibly complicated for the average investor, and executing a trade incorrectly can do permanent damage to a portfolio. A summary of my conversation with Jake is below, but I wanted to share this disclaimer and note that I believe anyone who wants to learn more about options should contact a fiduciary wealth advisor who has demonstrated experience in this advanced trading strategy.

Jake:?Let’s start by?defining an option. An option is a derivative contract of another security and trades on its own platform – the Chicago Board of Options Exchange (CBOE). We say derivative because options are contracts with terms that are based on price, volatility, and time variables. An option is essentially a security on top of a security. When you trade options, you’re executing a trade based on assumptions around price direction, implied volatility, and time.

In this conversation, we will mostly discuss options as they relate to stocks. Every option contract represents 100 shares of a stock. This is one reason we typically only trade options for clients who have at least $1 million in their portfolio. Trading options doesn’t make as much sense for smaller accounts. You need to own a lot of shares to potentially benefit from trading options. There are many options trading strategies and we use one called “covered call writing.”?I think the illustration below does a nice job of showing what it means to apply a covered call strategy. When we use this strategy, we offer outside investors the opportunity to buy stocks that our clients own during a certain length of time at a certain price.

An example: Let’s say a client named Tom has 100 shares of XYZ stock and it’s currently trading at $40 a share. In this scenario, we may sell a covered call for $45 a share (and the calls we typically for clients expire one month from the day we sell the call). So essentially, Tom is selling an investor the right to buy 100 shares of XYZ stock at $45 a share between now and one month from today, when the contract expires.

In exchange for agreeing to this, Tom will receive a premium on the option contract—for the sake of the example, we will say Tom will receive $1 a share, for a total premium of $100. This premium is the primary reason we trade options for clients. They’re a way to generate?income?for clients who qualify for this strategy.

So over the next month, if XYZ stock begins trading at $45 or more per share, the holder of that contract has the option to buy those 100 shares from Tom. If the stock doesn’t hit $45 in that month, Tom can keep his 100 shares. In either of these outcomes, Tom gets to keep the $100 premium.

So what’s the risk in trading options? If XYZ stock were to shoot up to $50, $75 or even $100 during that one month period, Tom would still have to sell it for $45 a share, because that’s what he agreed to in the contract. This means it doesn’t usually make sense to trade options on a stock that you’re hoping will rise in value significantly.

As I mentioned, at?Falcon Wealth Advisors, we trade options in large part because we want to receive that premium—$100 in Tom’s example—because it’s income we can generate for our clients. And we only aim to trade options on stocks that we believe have already hit their peak or that are close. With that being said, no one can predict the future, including our team.

Cory:?Yes, that’s all well said, Jake. It’s worth reiterating that the investor Tom enters into a contract with is paying for the?right?to buy his shares at a higher price in the future. That begs the question: why would this investor want to agree to that contract with Tom? Why wouldn’t they just buy the shares at today’s price of $40 a share?

Jake:?That’s a good question. The people buying these contracts are often speculators—sadly, they’re typically regarded as “fools” on Wall Street. Many of them may not have a lot of money to invest, and in our example, it’s a lot cheaper for them to spend $100 on that premium rather than buying 100 shares of stock at $40 a share. Broadly speaking, many of these speculators are comfortable risking the $100 for the chance to buy a rising stock for less than it’s worth.

We typically don’t just?buy?options contracts for our clients because we consider buying them to be too risky. But we are happy to collect income for our clients by agreeing to be a seller. Most of our clients are high net-worth families and individuals, and their main priority is generating income and mitigating risk. They don’t have to make risky investments in hopes of doubling their money.

As you can see, options are a complex topic and it’s easy to make a mistake if you’re not experienced at trading them. That’s why we recommend working with a team of fiduciary wealth advisors like?Falcon Wealth Advisors?if you want to trade options. We have experience executing thousands of these types of contracts over the years and we can closely monitor the contract while it’s in place.

Cory:?Another benefit of a covered call strategy is it forces an investor to have some discipline regarding?when?they sell stocks. As humans, it’s natural for us to say, “I have this stock worth $40 and I’m going to sell it when it hits $45.” But once it is worth $45, we often think, “Well, I believe it will keep going up. I will actually sell when it hits $50.” The problem, of course, is that the stock market isn’t linear and stocks don’t always go up in value indefinitely. Using covered calls forces us to sell stocks when they’re high—and as we often say, we aim to buy low and sell high.

Jake:?Indeed, Cory.?Fear and greed?can drive financial decisions that harm your financial plan. A covered call strategy can help reduce their influence. That’s another reason to work with a fiduciary wealth advisor who can help you avoid emotional decisions.

And let’s say you agree to sell a stock at $45 but it goes up to $50. A complex strategy we occasionally help clients execute is called rolling the option. This involves buying the option back and selling a new one so that you’re not forced to sell. But investors who choose to execute covered calls shouldn’t necessarily count on being able to roll the option.

It’s worth noting there aren’t options contracts on?financial products?like mutual funds or annuities. And you typically can’t use the covered calls strategy in?401(k) plans. This is not a concern for?Falcon Wealth Advisors?clients, as we use individual stocks and bonds.

Cory:?Jake, if a client chooses to execute the covered calls strategy, do you have any expectations on how it can enhance their overall returns? And is there a certain market environment that better lends itself to this strategy?

Jake:?The covered calls strategy is useful in volatile markets, or even declining markets, as investors can receive higher premiums in those environments. It’s harder to execute in a market that’s going straight up. And while Charles Schwab, the custodian of many of our clients’ accounts, charges a fee to execute covered calls, we absorb that cost for our clients.

Using covered calls is not a perfect strategy, but it’s something we do for specific clients as an overlay to our stock and bond allocation. It’s a singles and doubles strategy—we don’t use it to try to hit home runs. But it works well for clients who are willing to take the risks associated with options to generate a predictable income stream through the premiums. If you want to learn more about covered calls, explore?the Options Industry Council, which has some educational videos. And of course if you would like to discuss how a covered calls strategy can fit into your?financial plan, you can email us at?[email protected]?and?[email protected].

Clients choose to work with us to enhance their financial literacy and explain exactly what?their?financial plan means to?them.

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.