The Answer is No
It feels like these days, everyone is trying to sell me insurance. Whether it’s a new electronic gadget or airline tickets, I have to opt out of the option to insure my purchases.
This topic has actually been a recurring tiff in my marriage as my wife has accused me of being embarrassingly rude on numerous occasions. “You were so short with that sales rep when he was presenting you the insurance option,” she would say, or “You wouldn’t even hear out the customer service team member when they were offering the additional coverage.” She isn’t wrong, from my perspective, I just wanted to save everyone time and be clear that the answer was, and always will be, no.
From a business point of view, these “add-on” insurance sales can be quite profitable. From a consumer point of view, I simply prefer to retain the risk on my cell phone and plane flights versus paying the insurance premiums. A lifetime of “no, thank you,” and I’m still regret-free on that front.
Lots of Options
My wife is right, though; I do need to be kinder and gentler in my approach. My reactions are just so knee-jerk, as I know the option exists, and I know I prefer to decline the option.
When it comes to investing, the same rule/preference applies – I’m just not interested in options. Options are a type of investment, a derivative to be specific, and they give the investor the “option” to buy or sell a defined amount of a particular security at a defined price during a defined time period.
Now, to be clear, I’m not a fan of talking about the more esoteric topics of investing here on Thoughts On Money, but I’ll make an exception today as I’ve received a few questions recently about options. Specifically, questions around strategies like selling calls and buying puts.
Options Defined
A quick crash course on options. Options come in two flavors: calls or puts. Calls are the option to buy; puts are the option to sell. Within these two flavors, you can be a buyer or a seller.
So, if you are buying a call, then you are buying the option to purchase a certain quantity of a stock at a certain price during a defined time period. If you are selling a call, then you are giving someone else the option to purchase a certain quantity of a stock at a certain price during a defined time period from you. You are either paying a premium, as an option buyer, or receiving a premium, as an option seller.
If you are buying a put, then you are buying the option to sell a certain quantity of a stock at a certain price during a defined time period, and the vice versa here would be selling a put.
I’m confident that what I just outlined in the paragraphs above will be insufficient if this is your first time familiarizing yourself with options, so I’d encourage you to enjoy some YouTube videos on the basics of options.
As mentioned, most inquiries I receive are regarding either a call writing strategy (covered calls) or buying puts, so let’s dive in a bit on those strategies.
Covered Calls
Just to add to the confusion here, the term “writing” is another word for selling. So, writing a call is, as stated above, giving someone else the option to purchase a certain quantity of a stock at a certain price during a defined time period from you. Since you are giving someone else this option, they are the buyer paying the premium, and you are the seller collecting the premium. You own the stock, sell the option, collect the premium, and essentially “juice up” the income on your investment. Here lies the attraction: investors seeking higher yields are drawn to these strategies based on the increased income driven by collecting premiums.
So, what’s the downside? Well, as any insurance company will tell you, as profitable as collecting the premiums is, it’s the paying out on claims that can be costly. In this case, “paying out on a claim” is when your counterparty exercises their option and claims your stock at the stated contract price. To help illustrate this, imagine you had ABC stock currently valued at $20. You then sell (write) an option allowing the option buyer to purchase your ABC shares at any time in the next 6 months at $25, and you collect a premium for this option contract. Then, the most amazing and unexpected news comes out in favor of the ABC company, skyrocketing the stock price to $40 a share. Incredible, right? Not so fast, you already agreed to sell those shares for $25, which is quite unfortunate in these circumstances. You walk away disappointed, and the option buyer is jumping for joy as they purchase a $40 stock at the bargain price of $25.
Opportunity Cost
So, yes, selling calls can increase the income or “juice up the yield” on your portfolio, but you also take quite a haircut on the upside (opportunity cost). This is a no-free-lunch reminder.
I ran a basic comparison of a broad market index versus a covered call index. The backtest results reflect exactly what you’d expect: a higher current income but a significant “give-up” on total return over time. To be exact, the annualized return on the covered call strategy was nearly half that of the market over the last five years. Hence, my hesitation towards these strategies, and an advocacy for other income-oriented solutions that don’t come at such a great opportunity cost.
Portfolio Insurance
Next, let’s take a look at strategies around buying puts. Again, when buying a put, you are buying the option to sell a certain quantity of a stock at a certain price during a defined time period. So, in our last example, we saw how profitable it was when buying a call at a certain strike price for a stock that then skyrocketed in price, but when does buying a put become profitable? When the stock price plummets. Again, our ABC stock is selling at $20, and because of your fear, anxiety, and intuition, you buy a put on ABC stock at $20. The most unfortunate news hit the headlines about the ABC company sending the stock price to $10. Bad news for ABC stock becomes good news for you, as your option (put) then allows you to sell this $10 stock to the counterparty for $20. Your profit is the difference in price minus the premium you paid.
As I shared, I’m not interested in writing calls (covered call strategies) based on the associated opportunity cost; I don’t want to give up my potential upside in exchange for the elevated current income. As for buying puts, I’m not interested in constantly paying premiums to just get payouts on rare occasions of surprise news to the downside.
We call these put buying strategies “portfolio insurance” because that’s exactly what they are. You are paying a consistent premium for a rare payout. In preparing for this article, I ran a quick report on a fund (Cambria Tail Risk) that “seeks to mitigate downside market risk by purchasing a portfolio of ‘out of the money’ put options on the S&P 500 Index, as well as U.S. Treasuries to potentially provide income.” The chart of this fund was exactly what I expected; it’s lost roughly half its value in the last 5 years, based on the cost of premiums, but along the way, it had large spikes to the upside during times of market turmoil (e.g., March 2020).
As you might expect, if I weren’t buying insurance on my tech gadgets and airline tickets, I’m also not buying it on my portfolio. I didn’t like selling calls that gave a haircut to my upside, and I don’t like buying puts that place a premium headwind on my returns.
Let’s also address a constant rebuttal I hear: “What if I simply buy puts only when things look to be getting ugly in markets?” First, I don’t think we ever know when ugly is coming, and second, if the consensus is that a storm is brewing, then those option prices (premiums) are even more expensive. I believe market timing is a fool’s errand, and the same truth applies to an investor trying to time when to buy puts.
Complexity & Taxes
I tried my best to take this complex topic and make it palatable and appropriate for Thoughts On Money. Yet, there is still a whole vocabulary and science behind options that go much beyond the scope of this article. In the most simple terms, you now have a basic understanding of why I don’t personally advocate or deploy strategies that write calls or buy puts.
Options are complex, and to be frank, they are incredibly dangerous for investors who don’t understand them. Warren Buffett once described certain derivatives as “financial weapons of mass destruction.” Back in 2020, a young man actually took his own life based on a misunderstanding of the losses associated with an options trade, leaving only a note to his parents stating, “How was a 20-year-old with no income able to get assigned almost a million dollars worth of leverage?”
Beyond the nuance and dangers of uninformed investors “playing” with options, there are also tax implications that need to be considered. Options are typically tax-inefficient instruments, so one needs to not only assess the validity of these strategies in their portfolio but also the tax impact.
At the end of the day, it’s ok to just say no. Yes, we should always state this conclusion with grace and patience, especially yours truly, but they are called options because you have the option to opt out. I personally believe you can build out a complete and well-diversified portfolio without having to resort to derivatives or options. I also see the value of derivatives when used in a professionally managed portfolio for a particular use or goal. What I’m advocating against here is the allure of the complex – investors seeking out strategies that seem sexy on the surface without understanding how the underlying parts work.
Again, I hope this was a helpful Options 101 education, and I hope you better understand my distaste for the insurance-for-everything culture we live in.
Until next time, friends…
