A previous post covered the valuation of options. Now let’s look at investment/speculation opportunities in the options markets.
Some people use options to defer or avoid taxes.
- Options strip out the dividend payments on stocks. If you’re a Canadian like me, this can be helpful if you want to avoid the withholding tax on US dividends.
- Instead of selling a stock, you can try to “sell” the stock with options. Some tax authorities won’t let you use a synthetic short position (short the call and go long the put with the same strike price) in a stock to defer taxes.
*You really should not listen to me for tax advice so I would encourage you to do your own research.
If your broker does not pay you interest for lending out the shares, then you could replicate your position with options instead. I wouldn’t bother with this though. If the borrow on your stock is expensive, you should probably be selling it because the short sellers know that the stock is going to collapse.
The way I look at options is this. For the most part, the options market is like a giant casino. Practically zero value is created by shuffling paper around. Generally, the expected value of an options trade is negative because no wealth is being created and there are transaction costs. You should only mess around with options if there is a really compelling case for them. For me good reasons are taxes, safe short selling, and mispriced options/stocks.
Short selling common stock is a very dangerous sport where you make very little money. History is littered with short sellers who were right but blew up anyways (go read Richard C. Sauer’s book Selling America Short). A safer way of shorting stocks is to buy put options. I am a huge fan of put options. You cannot get bought-in, short squeezed, etc. You can have sizable positions in your best ideas.
A possible downside to put options is that you may be overpaying for volatility / the options. Of course, you don’t have to short the common or go long the puts. You can simply wait around for the fat pitch where the put options are cheap. On the other hand, the best shorts almost never have cheap puts. It may be worth buying the puts even though they aren’t obviously cheap and seem correctly priced.
Whether or not an option is cheap is a tricky subject and you definitely shouldn’t take my word on it. However, here are the things I look at:
- The cheapest options are around the low 20s in terms of IV (implied volatility) or the high 10s. SPY, the S&P 500 ETF, is a good proxy for what’s cheap. A highly diversified basket of stocks should have lower volatility than most individual stocks. A few select stocks have options that are actually cheaper than those for SPY.
For individual stocks, I consider IV in the 30s to be on the cheap side. IV in the 60s is expensive and is the high end of what I would consider paying for a put option.
- If IV for an at-the-money option is the same as historical volatility, I would consider the option to be reasonably priced. (Though the timing of earnings may play a role if the option is short-term.)
- There should be a small amount of a volatility smile. If there is no smile… somebody may be making a mistake.
- Mr. Market’s mood swings also affect the options market. Implied volatility tends to fluctuate just like stock prices.
- It’s a good idea to be patient and to wait for a good margin of safety. However, I wouldn’t claim that I do this (even though I should).
Buying options versus selling them
I’m a fan of buying options instead of selling them. When you buy options, you have a lot of upside and limited downside. You are much less likely to get into trouble from buying options than selling them. You have the potential for a higher rate of return and you have fewer ways of blowing up.
One setup is to look for companies that have recently conducted a secondary offering. Most of the time what happens is that the stock will rally well above the offering price (because the brokers pump the stock so any clients who bought into offering are happy… in the short run). Wait for the rally, then buy the puts if they are cheap. I want to find companies that will collapse quickly. This is hard because most shorts don’t have a catalyst. Usually the catalyst that brings about the downfall of these companies is earnings. Maybe a third or a half of the down move happens in the few days after earnings, if the stock even collapses. STEC turned out to be a good short for me in the $30s as they released bad earnings forecasts in the quarter after the CEO sold his shares in a secondary offering.
Most stocks with short interest about 15% are flawed and will one day collapse. Unfortunately these heavily shorted stocks tend to have expensive borrows which make the common stock unattractive and the put options too expensive.
This is the only options setup where I can say I have made a lot of money. However, it is uncertain if any of the strategies in this blog post are good ones.
As suggested in Greenblatt’s You Too Can be a Stock Market Genius, you can use long-term call options to leverage long positions. Options can be very compelling in situations where the underlying business may be very risky, e.g. the business is highly leveraged. I’m surprised at how cheap options are on many highly leveraged businesses (e.g. Autozone/AZO)… it seems that the underlying leverage of a business sometimes isn’t factored into options pricing. I don’t have a position Autozone, but its LEAPs look far more compelling to me than the common stock.
You have to look at each takeover on a case-by-case basis.
At one point in time, I though that the Potash takeover wouldn’t close because Potash’s management was against it. Potash’s CEO has a reasonable amount of skin in the game and an impressive track record of value creation. I didn’t think that the wanted BHP Biliton running/ruining his company. I also (incorrectly) thought that the stock price would fall after the takeover bid failed. So, I bought some long-term put options on Potash. The takeover failed, the stock dipped a bit… enough for me to get out at a small profit. I really have no idea what I’m doing when it comes to takeovers.
One potential play right now are puts on Focus Media (FMCN). (I own a few puts.) The Bronte Capital blog has extensive discussion on this Chinese reverse merger if you search the blog. There is uncertainty as to whether or not the takeover will fail its due diligence (as Bronte is hoping). The bet is extremely asymmetrical. The put options may be worth it if the chance of the takeover failing is not that much of a longshot.
You can use options to speculate on price going up once it a spinoff is completed (as mentioned in Joel Greenblatt’s book). However, I find that stocks don’t usually pop around a spinoff. One stock that did pop was IDT when it spun off CTMMA/CTMMB… however it was a small cap at the time and did not have a liquid options market.