For many, the world of options can be daunting for those who feel that they do not have the right experience. Certainly, the terminology used by options traders can be confusing for those who aren’t fully familiar. Our language primer is meant to translate how options behave and create a better understanding of how they are priced.
More importantly though, people often underestimate their own experience. If you’re in any way managing your family finances, then you have experience with options. Probably in a different language, but the practical applications of the concepts are identical. Here we’ll cover some very basic options trades and how you are already making those trades in your day-to-day financial life.
Long a Put
A put option is the right to sell a specific number of shares of stock at a stated price over a given period. Going long a put (or buying a put if you prefer that) is essentially term insurance against a stock losing value beyond a specific price point. Put buying is one of the first things you do as you become financially independent. For instance, when you get your first car you will need to insure it. Insurance protects the equity you have in the car should you get in an accident. In the event of an accident, you get a lump sum payout from the insurance company.
The beauty of the arrangement is that you can take small known losses (the premiums) to protect against the catastrophic unknown loss of having to buy an entire car at an unexpected time. This is not at all different from taking the proceeds from a long-put position, and buying more stocks when the market declines.
The same is true with life insurance. Your ability to earn an income represents the equity of your own human capital, and the income you receive can be thought of as dividends from that equity. Apologies for being morbid, but if something were to happen to you, the equity value of that capital immediately goes to zero. If you have a family relying on that capital to maintain their standard of living, it represents a loss that is unrecoverable.
Life insurance is essentially an “at-the-money” put on your human capital. That is why whole life insurance is so expensive, you are asking the insurance company to sell you a put option that never expires. When you were considering term vs. whole life along with all the other considerations that go into that purchase, that is conceptually no different than an options trader trying to figure out the best hedge for their portfolio along with the most appropriate cost.
Long a Call
One of the clearest examples of a long call option is the “earnest money deposit” that you make when going through the home buying process. When you make an offer on a home and the seller accepts that offer, the 1-3% deposit you make prior to closing is like a call option. It has a strike price (sale price) and an expiration date (closing date). Let’s say that during inspection there are issues with the home that are uncovered, and you no longer wish to buy the home at your original offer price. If you walk away, you only lose your deposit. How is that any different than a call option on a stock that failed to go “in the money”? The earnest money deposit is the right but not the obligation to buy a home at a stated price by a stated date. If you ever bought a home, you were trading a call option.
Short Calls and Puts
Changing course a bit, let’s talk about being short options and how that looks in your financial life. Intuitively, being long options makes more sense for most, since we are typically looking to reduce risk in our financial lives and create more certainty. One of the challenges of being the option seller is that someone else is paying you premiums for to accept the risk for the entire given period.
What is critical to understand when you are selling options is that your approach to risk management must evolve. Long options have a risk management feature already built into them; your maximum loss is capped at the premium. On the other hand, when you are short an option (or selling the option), your potential losses are much larger than the premiums or income that are coming in. Risk management becomes imperative in that scenario.
This is what made the 2008 mortgage crisis so problematic. The largest financial institutions in the world put on the exact same trade, they sold out of the money puts on the U.S. mortgage market and then leveraged that trade massively because their models told them that those puts could never go into the money. Yes, it really was that stupid. When those puts went in the money, life got…interesting.
At this point you are likely understandably thinking: “Ok, got it, I should only buy options because selling them sounds really scary.” Yet there are meaningful advantages to selling options, provided that you understand how to manage your risks. Selling options delivers consistent income and when you retired, your portfolio might transition from one that looks like a “long calls” portfolio to one that looks more like a short call and puts portfolio, or a “short straddle” if you want to sound more technical.
Moving from growth stocks to dividend stocks is an example of going from long calls to selling calls. The dividends give you income now, and you accept the tradeoff that your upside on those stocks will be somewhat capped. On the short put side, if you ever got a savings bond as a kid or have a target date fund in your 401(k) then guess what, you are selling puts.
A bond is functionally a short put trade. If you are buying Treasuries and investment-grade corporate bonds, you are managing your risk since there is a low likelihood of those puts going into the money. The compromise is that you will not receive a very high premium for doing so. However, if that premium is sufficient, then taking on additional risk for a bit more income isn’t going to make a whole lot of sense. This is exactly why investment opportunities that are sold on income that sound too good to be true should be greeted with a great deal of skepticism. Remember, if you do not understand the yield then it is a pretty good bet that you are the yield.
The world of options trading may seem intimidating at first, but it becomes much clearer when we recognize that many of the concepts are already present in our everyday financial lives. From buying car insurance to making earnest money deposits on a home, these are all practical examples of options in action. Similarly, even the more complex strategies, like selling options, have parallels in common financial activities like investing in bonds or managing dividend stocks.
By acknowledging these connections, it becomes easier to see that we all engage with options, often without even realizing it. Whether you’re hedging risk or seeking income, the core principles of options trading mirror decisions many of us make daily, allowing us to approach the world of options with greater confidence and understanding.
Disclosures
Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.
Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2501-5.
