The kinky stuff

  By Guest Blogger Sinan Terzioglu

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This post is about naked options and short strangles. But please don’t get too aroused. After all, I’m one of Garth’s nerdy financial guys. We don’t get out much.

Following my debut post here, some commenters asked about options. An option is a financial contract giving an investor the right, but not the obligation, to buy or sell an underlying asset at a pre-determined price (the strike price) on or before a specified date (the expiration date). Options are derivatives – their prices are derived from that of an asset like a stock, index, currency or commodity. Institutional and retail investors use various strategies in an effort to improve cost basis, hedge risk and speculate.

At Turner Investments, we don’t utilize any options strategies. They encourage too much trading, and over-trading is one of the most common reasons so many investors underperform over time. Also, frequent trading is expensive, complicates taxes and most importantly trading options can be extremely risky if not used responsibly.

There are two types of options contracts: calls and puts. A buyer of a call option has the right to buy the underlying asset for a strike price on or before the expiration date. The buyer of a put option has the right to sell the underlying asset for a certain price on or before a specific date.

Every option represents a contract between the writer of the option and the buyer of the option. The writer of the options contract “writes” or creates the contract, and sells it for a premium. With a stock or ETF underlying, one option contract represents 100 shares. Option prices, also known as options premiums, are determined by three variables:

• Time – How much time is there until the contract expires. The more time the more value is given to the option.
• Volatility – The more volatile the underlying asset, the more value is given by the market maker to the price of the option.
• Intrinsic Value – Is the strike price of the option above or below the current price of the underlying? For example, if stock XYZ is trading at $105 per share and you are looking at a $100 strike option, you would know there is at least $5 per share in intrinsic value so the price of the option will be at least $5 + time value + volatility value.

Some investors utilize various options strategies such as the covered call and the cash secured put write successfully over time. Both of these strategies requires owning at least 100 shares of a particular stock/ETF (or be willing to own 100 shares) and collect a premium to enter the contract. The premium collected is considered income or a cost basis reduction. The strategy can work well in certain market environments and not so well in others, so it’s never a sure thing.  Compared to all other options strategies, these two are relatively much lower in risk.

The problem many retail investors and even money managers get into from time to time is they start to use options to speculate on short term price movements. Various strategies involve significant leverage and unlimited risk – a recipe for eventual disaster. The allure of some of these strategies is that they work well for periods of time and lead some to believe they have discovered the holy grail of trading as money can be earned nearly effortlessly. However, where people get themselves into trouble is not understanding the true nature of market risk especially when combining it with leverage.

One client I worked with was interested in utilizing cost basis reduction strategies for his investment portfolio but as he became more knowledgeable about options, he started using a strategy known as the short strangle. He soon went from investor to speculator. I tried steering him away from this popular strategy but unfortunately he didn’t listen, saying he could handle the risk. The short strangle involves the selling of a put option and the selling of a naked call option which means not owning the underlying asset and taking on unlimited risk on the call side.  With this strategy one is betting that an underlying, such as an ETF that tracks the S&P 500, will stay within a range, like +/- 3%, from its current level.  The seller of a short strangle collects a premium on each of the put and call options sold. Sellers of short strangles take comfort in the fact that the probability of success can often be 70-80%+ depending on the strikes chosen. The strategy will be profitable if the underlying stays within a range over a certain period of time but the problem is one collects very little for the risk taken.

My former client became increasingly confident using this strategy throughout 2017 and sold more and more contracts so he could collect more in premiums. Compounding the problem for people trading options is brokerages allow you to enter contracts on margin (borrowed money) so those using this strategy expose themselves to enormous leverage when they get overconfident and greedy. Needless to say leverage works well when one is on the right side of it but not so well on the wrong side. Like my former client, many using this strategy don’t understand the options market is priced the way it is for a reason and even though a price move of +/-5% may have a less than 1% probability of happening, it can happen and will happen from time to time.

In February 2018, the markets came under enormous pressure and volatility sky rocketed.  My former client had short strangles on the S&P 500 and the puts he sold were now in the money (meaning the market had dropped so he would be forced to buy).  He was like a deer caught in the headlights. He had said he could handle the risk but he clearly couldn’t. The market was moving so quickly against him that he basically froze.  He didn’t want to lock in losses but desperately wanted to believe that the market would recover.  He was kicking the can down the road and even considered selling more strangles to average down. The problem was his account was over levered and he was getting a margin call.  Selling short strangles and collecting very little relative to the risk taken is like trying to collect change in front of a bulldozer. Eventually you’re going to trip and get squished.  People kid themselves when they think they’ll be able to react to the sudden price movements of a plunging market.  My former client had unfortunately devoted a decent amount of capital to the strategy and as a result was cleaned out.

Even so-called professional managers make the same mistakes. One recent example cited here a few weeks ago was of a hedge fund manager selling uncovered call options on natural gas futures and losing all $150 million of his client’s money. That has to be one of the most ridiculous strategies ever used by a pro because selling uncovered calls on a commodity that can easily swing +/-10% in a given day is pure gambling.

When something seems too good to be true in the financial markets, trust me, it is. The only free lunch in investing is diversification. That’s why we build balanced and diversified portfolios and leave the speculating to others.  No strangles. No nakedness. Sorry.

Sinan Terzioglu, CFA, CIM, is a financial advisor and licensed portfolio manager with Turner Investments, Private Client Group, Raymond James Ltd.