Options are an excellent tool for
value investors. 
Value investors who rely on Fair Value Estimates (FVE) to arrive at
Buy/Sell decisions tend to use a two-pronged approach:
Value investors who rely on Fair Value Estimates (FVE) to arrive at
Buy/Sell decisions tend to use a two-pronged approach:- Bottom-up fundamental analysis, and
- Macro considerations
Rather than using a fixed FVE,
value investors rely on a range of FVE’s based on the assumptions and methods
used. With a range of FVE’s in place, the Buy decision can be based on a
margin-of-safety around the low-point of the FVE’s and the Sell decision when
the market value approaches the FVE.
Macro environment can cause the
overall market to stay significantly undervalued or overvalued for extended
periods of time. In times of market undervaluation, it is easier for value
investors to stay fully invested while the reverse is true during periods of
significant market overvaluation. Hanging on to cash under such circumstances
can result in value investors missing out by a long chalk as cash holdings
rarely provide significant returns. This, in essence, is the bane of long-only
value investors.
Value investors would be better
off with a long-short portfolio instead of one laden with longs only. Then,
value investors can opt to stretch their short-portfolio when the macro picture
indicates the overall market overextended and shrink the same when the macro
points to the contrary. The approach is not without downsides:
a)
Open-Ended Risk:
The losses can be limitless while the returns are capped as the stock cannot
dip beyond zero. For e.g., the maximum profit from shorting 100 shares of a $50
stock of ABC is 100% of the proceeds received when shorting ($5,000) – realized
if the stock goes to zero. On the other hand, if the stock goes to $150 and the
decision is to close the position, the loss is 200% of the proceeds received
when shorting ($10,000) – theoretically, the losses have no limit as there is
no ceiling for the stock price of a company.
b)
Costs:
Several expenses are associated with shorting stock - the fees the broker
charges for borrowing the shares, dividend payment on short position, and
margin costs. A part of the cost may be offset if interest is earned on the
short proceeds. The cost increases as the position is held for extended periods
of time.
Options based strategies are a
valuable tool for value investors. Below lists some of the most basic option
strategies that can be employed:
a)
Short Puts:
Short puts involve selling put options on a stock at a particular strike price.
The expectation is that the stock will stay above the strike price during the
option period allowing one to pocket the premium realized as pure profit. But,
one is obligated to buy the stock, if and when assigned. Hence, it is best to
write cash-covered puts – meaning one has the liquidity to buy the stock at the
strike price. Short puts are a way for value investors to potentially enter a
stock at a price they wish to enter. For e.g., say the FVE
indicates stock ABC is a good value at $30 or below and the stock is currently
trading at $35. An option in this scenario would be to sell put options on ABC
at $30. If the stock stays over $30, the investor gets to keep the premium
received. But, if it went below $30, most probably the stock would be assigned
and the investor would own the shares at $30. The downside is the value of the position at the strike price, if the option was assigned. For this reason, it is best to view short put
positions as though one is long on the stock at the option strike price in an
amount equal to the contract size – if the sale were for 5 contracts, assume
one is long 500 shares.
b)
Long Puts:
Long puts involve buying put options on a stock at a particular strike price.
Though the put premium needs to be paid out, it provides protection, if the
investor owns the underlying shares. For e.g., say one has ownership of a
stable stock XYZ at a cost-basis of $25. The stock is currently trading at $50
and the investor still thinks there is a good margin-of-safety at the current
price. But, since the stock has gone up, there is an urge to protect the gains.
In such a situation, long puts are value investors ally. It provides a way to
protect the gains against a stock decline for the price of the premium, while
keeping the upside intact.
c)
Short Calls:
Short calls involve selling call options on a stock at a particular strike
price. The expectation is that the stock will stay below the strike price
during the option period, thereby allowing the investor to pocket the premium
realized as pure profit. But, the investor is obligated to give away the stock
at the strike price, if assigned. Hence, it is best to write covered calls –
meaning one is long the underlying stock in an amount equal to the contract size
– if selling 5 contracts ensure one is also long 500 shares. For value
investors, short calls allow a way to realize periodic income on a stock. The
strategy can be used against one’s long positions when the overall market and the
stocks involved are fairly valued or over-extended. One is spared from selling
the stock as it is unclear how long the macro situation will prevail. In this
scenario, using covered calls help realize periodic income, embellishing one’s
returns.
d) Long Calls: Long calls involve buying call
options on a stock at a particular strike price. The expectation is that the
stock will go well above the strike price during the option period, allowing
one to realize potentially huge profits in a short period of time (option
period). Should the stock stay below the strike price, the call premium is
lost. Value investors can apply this strategy with stocks that have a chance to go up significantly over a short period of time, should an anticipated event occur. For e.g., say
the stock of a company, known to have a history of blowing past earnings
expectation once every few quarters, is trading at $100. Research has narrowed
down on the fact that the coming quarter is one of those quarters. In this
situation, value investors can opt for long calls covering the quarterly report
at a strike price of $100 for say $10. If the stock moves as expected to $130
immediately after the earnings release, the money invested have tripled. On the
other hand, if the investor were to go long the same amount of shares at $100,
the returns would have been just 30% following the quarter report and stock
move.
Related Posts:
- Cash holdings in an investment portfolio - strategies to squeeze income for value investors
- Kelly Criterion based Strategies for Value Investing
- Covered Call Strategy for Stable Income Portfolio
- Basics of Options and Futures for Value Investors
- Basic Options Strategies for Value Investors
- Basic Futures Strategies for Value Investors
- Short Selling Strategy for Value Investors
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