Option Basics

A Value Investors view

Summary

The Federal Reserve in the US is continuing to raise rates and markets are correcting. Some businesses are looking like they will or are trading at a discount to their intrinsic value.  As a Value Investor it is important to have an intrinsic value for businesses you are interested in owning and a Thesis to go along with it.   This ensures that the decision making process remains rational or reasonable when everything falls apart and fear is at its highest.   One of the main principles of Value Investing is that we do not attempt to time markets.  Nobody, even extremely intelligent individuals, have crystal balls that tell the future. Value Investors simply try to buy businesses that have competitive advantages at less than the intrinsic value of the business.  It is times like right now that create the opportunities for unmatched growth for a lifetime.

Black Opal Research believes that when we understand the businesses we invest in, and have a long term time horizon, we can act reasonably and avoid the ups and downs of the market. Some of the largest, and best managed long term oriented businesses don’t often trade at a price that would offer a margin of safety entry point.  For that reason, today we have put a little bit of information together on Options. This may encourage some to think differently about engineering margin of safety prices.

Please keep in mind that we are not providing financial advice.  We are not your financial advisor and do not know your personal situation, investment time horizon, or risk appetite.  We are only attempting to lay the ground work for some of our future thesis and the two interesting examples at the end of the article, where we speak about entry strategies utilizing derivatives.  In order to understand the thesis you will need to understand the very basics about options.

This article is different than what we normally publish and because of that, we are looking for feedback from our subscribers and readers. You can get in touch with us on twitter @BlackopalMOS, at the bottom of the article, or by sending us an email. We hope you enjoy the information below.

Options

Options are contracts between two parties.  Each contract has a buyer, seller, strike price, and expiry date.  There are two different types of options contracts that exist and the names for them are "Call" options and "Put" options.  With options the key thing to remember is that Buyers have rights and Sellers have obligations.  Additionally, each individual contract is tied to 100 shares of the underlying security.  For example, one contract of BRK.B is tied to 100 shares of Berkshire Hathaway.  This is important for when you are reviewing your total obligation or rights of the contract you are writing or purchasing.    

Call Options

Call options are financial derivatives that give the buyer the right to purchase shares in a company at a set price known as the Strike Price. On the other side of the the trade the seller of a call option is obligated to sell shares of the business at the strike price. Both of these things will only occur if the respective strike price is located in the money.

For example An investor sells to open (STO) a call on a underlying asset with a strike price of $100.00. During the length of the contract the underlying asset trades above the strike price of the call option sold at expiry. In this circumstance the seller would be obligated to provide the buyer 100 shares of the underlying asset for $100.00 per share irregardless of the current Asset market price.

Covered Call

A covered call is where an investor sells to open a call option on a security that they own 100 shares of, or however many shares require to cover the amount of contracts sold.  The seller receives a premium from the purchaser  and obligates themselves to sell their shares at a set price on the future date of the contract if the share price is above the agreed to strike price of the contract.

Said differently, the seller is paid for providing the purchaser a right to buy shares at a set price some time in the future.  With this type of option the risk an investor has is that the shares owned will be called away for the agreed upon price.  This is a great way to exit a position and increase the rate of return on an investment. 

For example if the investor own shares in company X the business is now trading far in excess of that value. As we saw in 2020, and 2021 the business may significantly be exceeding the calculated reasonable value of the business. Instead of just selling your shares you could Sell to Open (STO) a short duration (two to four weeks out) Call option at the current market price.

This will provide you with a premium today, lets call it $5.00 on a 100.00.  This is only an additional 5% on the current price of the stock but, on your adjusted cost basis of $25.00 it could be an additional 20% return on your initial investment.  If the stock price goes down below the strike price that your call was sold, the investor gets the 20% return and keeps their shares. They can then turn around and do it again at a lower or the same exit price as before.

A key item to remember and possibly a limiting factor is that in order to sell one Covered Call you must own 100 shares of the underlying security.  If you don’t, you will not be able to complete this trade.  Remember that one contract is worth 100 shares and if you don’t have 100 shares of the equity you would be completing a naked call. 

Naked Call

A Naked Call is a contract where an Investor sells to open (STO) a call option on a underlying asset that they do not currently own enough shares in to cover the amount of obligations that they entered into.  This is a very dangerous and speculative approach that has serious financial risk.  If at expiry your strike price is in the money, an investor who purchased your Naked call would have the right to call shares from you that you don’t have.  In order to provide those shares you would have to purchase them in the open market at market price and then transfer them at the lower contracted strike price to the buyer. 

This is a scenario that some hedge funds experienced with AMC or GME.  If for example you Sold to Open (STO) 1 contract in the form of a naked call on GME at a strike price of 15$ you may have received a premium from the buyer of $1.00/share.   You put that $100 in the bank today and are happy with the return because you expect GME to drop through the floor and go bankrupt, who buys games on disks anymore…….

GME skyrockets to $120.00/share for the contract expiry that you have entered into and you are stuck holding the bag.  Since you didn’t have any shares to cover the obligation that you entered into, you must purchase 100 shares at $120 costing you $12,000/contract.  The point is that selling naked  call options leaves you open to significant market fluctuations and financial risk that you may not be able to afford.  . 

Put Option

A Put is a type of financial derivative where the seller obligates themselves buy 100 shares of the underlying asset at the strike price in exchange for a premium at the time the contract is opened. The buyer has the right but not the obligation to sell the shares at the agreed upon strike price as long as the strike price is in the money.

Purchasing puts can be used as a form of insurance on your securities to protect yourself from market changes. This is one of the most common uses. Puts can also be used to bet against stocks or indexes that are overvalued.

Naked Put

A Naked Put is where an investor Sells to Open (STO) a put contract.  This obligates the investor to purchase shares of a business at the agreed upon price.  The risk of selling a naked put is that the security could go to zero and an investor would still be required to purchase the shares at the agreed upon price.  The maximum risk is the number of contracts multiplied by 100 and then strike price.  This makes Naked puts a great way to adjust your cost basis as well as open a new position.

When you know the intrinsic value of a business, you create a significant advantage over other investors.  For example, If an investor knows that they want to buy Alphabet at $80.00, because its intrinsic value is $160.00, they could sell a short or long duration put with a strike price of $80.00.  This will generate a premium for the investor today prior to any shares being owned.  If the shares are put to the investor, great!  The investor wanted to own the business at a discount to intrinsic value and the strike price is at or below that Value.  If the option expires, great, the investor keeps the premium and can either purchase shares or sell another put at a higher strike price due to the adjusted cost basis from the first premium received. This is a strategy that has been used by Berkshire Hathaway when they purchased Burlington Northern and Coca-Cola. 

Bull put spread (BPS).

A bull put spread is a type of option where an investor both sells contracts and buys contracts in the same trade.  The Investor sells to open (STO) a put at a certain strike price and in the same trade, buys to open (BTO) a put at a lower strike price.  The difference between these two prices is the spread. 

The spread between the two prices changes the math for the Investor regarding capital at risk for the trade and reduces the impact to the investors cash or margin account. This type of trade generally will increase the annualized return on risk capital because you are only risking the loss of the spread unless the underlying asset price finishes between the two strike prices. For this reason this is not the type of trade to utilize if the Investor is not going to pay constant attention to it.   

For example, if the Investor STO 1 put contract of company x at $100.00, the capital that the investor would be obligating themselves to utilize would be $100.00x100 shares = $10,000.00 less the premium generated.  At this point the investor has $10,000.00 at risk but has generated a return. Then the investor (in the same trade) BTO 1 put contract of Company X at a strike price of $95.00 and pays a premium for the insurance.

If Company X stock price goes to zero, the investor now does not lose the $10,000.00.  They would only lose the entirety of the spread.  To think of it from a process standpoint, the investor would be put the shares at $100.00 per share at expiry or possibly before expiry, and then they would turn around right away and put the shares to whomever sold them insurance at $95.00.  In this situation the investor only loses $500.00.

The premium is much smaller per contract when selling spreads as opposed to just selling a put. The return on risked capital however is generally a higher rate of return. In most circumstances on underlying assets that have a large derivative market, the difference is significant.

Real World Examples

For those of you that have read our previous thesis, we have looked at both Alphabet and Meta to determine their intrinsic value based on different evaluation methodologies.  On Thursday September 29, 2022 we found some oddly profitable option chains that provided a decent annualized return on risk capital RORC.  The risk capital as we define is would be the amount of money that we would be putting out if our option was exercised (For Simplicity).  The first trade on Alphabet generated a 7.3% Return, and the second trade on Meta generated a 35.8% return on risk capital.

We hope the real life examples below help our subscribers understand the value of options. There is no cost of subscription so please subscribe if you find our research and information valuable.

Alphabet GOOG 0.00%↑

As our previous thesis will tell you we believe that Alphabets intrinsic value is between $100.00- $160.00 per share.  If you haven't read our article on alphabet take a look at it on our page.  On Thursday, September 29, 2022 investors were able to generate a $5.60 premium by Selling to Open (STO) a put with September 15, 2023 expiry at a strike price of $80.00.  This represents an immediate 7.3% annualized return.  Our readers will also note that this price is a 50% discount to what we believe Alphabets intrinsic value is today providing an incredible margin of safety for the investor over the long term. The below image shows this trade using think or swims platform.

The investor is obligated to purchase the 100 share of GOOG at the strike price of $80.00 if GOOG stock drops below that price over the next year.  Therfore the risk capital in this trade is $80*100=$8,000.00. If the investor wants to own GOOG, they would hope the shares are put. If for some reason over the next year the stock never goes below the strike price, or it does and the investor isn’t put the shares, a rate of return on cash in their account is still generated.

Additionally, If over the next few months GOOG stock price trends up, the amount it will cost us to purchase the option back will decrease.  In this situation our annualized return on risk capital will significantly improve as we could Buy to close (BTC) the option for pennies and wait for another market fluctuation to capitalize on our entry price again in the next year.  At the end of this article we will lay out how investors can themselves go and back test historical option prices on individual US equities for free.  If you are learning this is a great thing to do in a play money account.

Meta META 0.00%↑

We have also published a thesis on META.  If you have not yet read it please have a read.  Our thesis on META has an intrinsic value on the business of around $200.00-$320.00/share.  A simple google search will tell you that META is trading significantly below that price and is continuing its decline further. 

On Thursday September 29, 2022, we discovered that a bull put spread (BPS) at a price far below our intrinsic value and even below our 50% margin of safety price was yielding a really nice return. The trade was to Sell to Open (STO) a put at $115 while at the same time Buying to Open (BTO) a Put at the next strike price below $110 for the September 15, 2023 expiry.  This means that the investor is obligated to buy the stock at $115 but has also at the same time purchased insurance at  $110.00.  the difference between the two strike prices is the risk capital. Below is a snapshot from Think or Swim showing the trade.

Assuming one contract, the investors risk capital is $5*100=$500.00.  On that $500.00, the investor would have generated a whopping $172.00.  This works out to be a 35.8% annualized return on risk capital today.  This is not the end of the value oriented trade because at any point in time in the future you can Sell to Close (STC) your long strike. 

While the timing of this does matter, the point is that if the Investor wants to own shares of this business at the short strike price, and you don’t want to tie up all the capital in your account while you wait for the price you want to own the business up, completing the BPS allows an investor to put up less capital until it is required.  If the price of the shares drops below the long strike it will receive a significant premium when it's sold.  This allows for an adjusted basis that is lower than the price the shares are put to the investor.     

Backtesting

Using derivatives can dial up an investors return, but it can also lead to significantly higher and unforeseen risks. Used properly, they can provide an advantage, but if used incorrectly they can lead to bankruptcy and the loss of a lifetime of savings. History has shown us that even extremely successful fund managers can quickly over leverage themselves and their funds via the use of derivatives. There are many hidden and unforeseen dangers when utilizing derivatives and any investor should use caution.

All investors should utilize paper trading accounts for options trading before attempting to implement strategies. TD Ameritrade has a platform called Think or Swim that is incredibly user friendly and is FREE. One of the advantages is that they have historical end of day CBOE option prices for American equities. You can see day by day see how your option chain changed over its duration. This information can help investors learn and implement different option strategies using historical data.

To Our Subscribers

The strategies we discussed show how even in a market that is correcting, there are ways to generate annual returns while minimizing the risks. This can only be accomplished by understanding the long term value of businesses. As our readers are aware, this article is different than some of our other pieces and we are looking for feedback. Was this useful? Or is this too complicated or unimportant?

Please feel free to suggest companies that you believe have a competitive advantage that you would like a thesis on. We may add the business to our list and complete a deep dive on it.

Black Opal Research