Financial advice: It's time to review your stock options

Financial advice: It's time to review your stock options

THINGS are more leisurely at the moment, as they usually are in the summer.

I know many business people who also enjoy a less manic, more relaxed cycle through July and August, before the pace of things picks up again in autumn.

Welcoming the ebb and flow of activity through the seasons makes a lot of sense, as it affords you some time to step back and take stock. And this is true for your finances and financial goals as well, whether personal or business.

Take the stock market for example. It’s in a funny place right now and many may well be following the old adage, “sell in May and go away”.

Also, the market is wondering if the 32-year bond bull run is finally over. Many countries are going through political turmoil. It’s an uncertain time. It’s difficult to know what’s going to happen.

In other words, it’s the ideal time to review your options — the derivative kind.

For those of you who aren’t familiar with the concept of options, in essence, they act as an insurance contract. To be technically correct, “an option is the right, but not the obligation, to buy a stock, at a predefined, locked-in price, at a predefined date in the future.”

The fact that one party doesn’t have an obligation, means that one party has the option to walk away from the deal.

Imagine that you are a pension fund manager and you have to pay out £2million next year. You don’t want to find yourself in a situation where you have any less than that amount in liquid cash when it comes to the payout.

However, you would like the potential upside that equities can offer, but you don’t want to take the risk that the price of the share could fall.

Options allow that fund manager to have their cake and eat it. They simply buy a “put option” at for example, £75,000 that gives them “the right, but not the obligation to sell” that stock.

This means that if the value falls below a certain level (called a strike price), at a certain time (called a strike date), they can call in the option and get the strike amount into the fund.

However, if the equities rise above the strike price by the strike date, then the deal is off and the seller of the option keeps the £75,000 for his or her flexibility.

Personally, I have been investing in options for years now and I usually take the position of the seller of the option and here is my rationale. If I believe that a stock will rise and I’m willing to buy that stock, then I could just buy the stock and wait for some upside.

Alternatively, I could sell the option to somebody else that they could sell it to me at a certain price at a certain time (aka sell a put option). Effectively, the person who wants to protect himself from the downside pays me to wait (via the premium) to buy the stock off him.

Ah, I hear you say, “But what if the price of the stock falls?” In that case, I am locked into an agreement to buy a stock at a higher price than it’s trading at that time.

You’re quite right. However, if I buy a stock and then it falls, don’t I leave myself open to the very same possibility? In fact, by selling an option, I have the cushion of the premium against a loss.

I have a personal golden rule. I will only sell put options on stocks that I would be happy to buy in the eventuality that I do actually have to pay out for them at the strike date.

I do not sell options on stocks just because I can get paid a premium. Similarly, I do not sell options on stocks that I wouldn’t hold in my portfolio anyway.

The market is quite volatile at the moment — Ben Bernanke has been introducing the word “tapering” into our everyday lexicon and the world hangs on every word of the FOMC minutes. It can be an unnerving time for an investor.

Personally, I see opportunity because volatility drives option premium prices. Like any form of insurance, when the risk rises, the price rises.

As a result, the inherent volatility in the market at the moment is driving premium prices higher making it all the more lucrative for somebody who is selling them, assuming that you can find a stock that you’re willing to hold right now.

Finally, the market may be moving in a direction in the short term or it may be “range bound”, which means it bounces around, but ultimately goes nowhere significant. If the latter happens to be the case, it’s difficult for a relatively inert investor to make money.

However, remember that an option seller is selling a finite insurance contract and hence, as time passes, so too does the value of the contract. In other words, an options seller is selling time.

In essence, you are getting paid to wait via the premium. In case that I didn’t mention it already, I would only consider selling  options for stocks that I’m interested to buy anyway, as I’m taking a position which will only work out if the price doesn’t fall (just like buying a stock directly).

At the moment we don’t know what is going to happen in the market. And, for all the volatility that we’re observing, and all the uncertainty in world news, step off the treadmill and evaluate.

In a flat market, options are a great way to make money. In a rising market, they can be a good source of income and exposure. If you feel that it’s going to fall, stay away, but take some time to review your options for when better times lie ahead.

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