#options basics

[universalinvestmentstrategies]

Options Basics

An option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.

[frankluengo]

Don’t Do It: Basics of Short Positions

Last week I wrote about Bill Ackman’s fight with Herbalife and his notorious short position and alleged influence over their stock price.

In the spirit of helping paint a clearer picture to events in financial markets, I wanted to show you some basics of short positions. Of course, much like showing you a video of a dangerous stunt, you should leave shorting to the professionals and don’t try it at home.

First, you should know that short positions live in the realm of speculation. Some want to call their short strategies investing, but I’m not a fan of that term because short positions require either a time horizon which is typically much shorter than you would need in investing, and are likely to require lots of debt or leverage. Both of these are investing no-nos in my books.

So I’ll break this form of speculation into three basic types:

Short selling

Selling call options

Buying put options

Short Selling

Short selling is the act of borrowing shares and selling them at the current market price. The short seller enters a position where they have cash from the sale of the stocks and owe the underlying asset of the sale. At some future point in time, the short seller has to pay back the shares, but since he does not own any, he must purchase them from the market. The speculation here is that when it comes time to pay back the shares, the share price will have dropped. Therefore the short seller will spend less money buying back the shares than the original proceeds of the short sale.

Let’s use Apple as an example. Today Apple closed at $127.04. Let’s say I think this will decrease soon so I decide to short sell 100 shares tomorrow (assume the price stays at $127.04 for one day). First I must borrow these shares from a broker, who will charge me a fee. I then sell the shares for the proceeds of $12,704, less the fee. Assume for the sake of this example that the fee is $0.

Let’s say that one month from now, Apple shares tumble to $100. At that point I can buy the 100 shares from the market for $10,000. I then return the shares to the lender and profit $2,704.

This all sounds great, but there is a rub. The lender won’t allow me to just use up the initial proceeds however I see fit. I must keep a certain amount of collateral for the shares I borrowed. This is called a margin requirement. Let’s say that my broker requires that I keep at least 50% of the value of the shares in cash and that I do nothing more than meet this minimum requirement. This leaves me with $6,352 in my margin account and the same in my pocket.

Now, let’s say that the next day Apple shares rise to $130. This means that now I have to ensure I have exactly $6,500 in my margin account. I have to make up the $148 deficit from the money I have in my pocket. This is called a margin call. If the stock continues to rise, which it can do indefinitely, I will be subject to continued margin calls and potentially be forced by the broker to close my position at a loss (situation called a short squeeze). In essence, the downside risk of short selling is infinite, because there is no limit to how much a stock could rise.

Selling Call Options

Another form of short position on a stock is to issue a call option contract and sell it in the market. The buyer of the contract pays you to have the option of buying the security from you at or before a specified future date, called the maturity date (European or American options) at a specific predetermined price, called the strike price.

If the price of the underlying security remains below the strike price until the maturity date the option will expire worthless and you will get to keep the proceeds of the options contract. If however, the price of the option goes above the strike price up to and including a future maturity date (American), or at a future maturity date (European), the holder of the option may exercise it. At this time you will have to buy the underlying shares from the market at the market price, and sell it to the holder of the contract at the strike price. The difference between the two prices, less the initial proceeds of the contract is your loss or profit.

Continuing the Apple example, the current cost of a 2 month (May 15) option with a strike price of $145 costs $1.02. For one contract of 100 shares I would have proceeds of $102. Therefore, if Apple shares stay below $145 I will keep all my proceeds. If share rise to $146.02, I will break even. Anything higher and I will incur a loss.

Similar margin rules as shot selling would apply in this case, and the potential loss is infinite.

Buying Put Options

The last, and simplest form of a short position is to buy put options. In this case you are paying the issuer of a options contract for the right to sell the shares at (European) or up to and including (American) a future maturity date at a specified strike price. If the shares go below the specified strike price you can exercise the option by buying the shares from the market and selling them to the issuer of the contract at the strike price.

Again, with the Apple example, you can buy a 2 month (May 15) put contract for 100 Apple shares at a strike price of $115 for $1.97 per share, for a total cost of $197. If apple shares fall below $113 you make a profit and may exercise the option at or below $115.

Unlike the previous short positions where you had positive cash flow when setting up the position, this position requires you to pay up front for the potential benefit in the future. Also, when buying a put option, the most the price can drop is the current stock price, so there is limited risk to the issuer of the contract. Your risk as the buyer is capped at the initial cost of setting up the position.

Now, before you call your broker and ask to buy put options, remember that you can still lose your shirt, because you are speculating on short term price movements, which not even the most savvy investors can do accurately. Moreover, you are paying a volatility premium which makes your expected returns negative unless you have a very good reason for betting against the issuer of the contract.

As for Bill Ackman, I’m pretty sure he knows what he’s doing. As for me, I’m happy to watch the stunt from the sidelines.