Wealth Systems: Options, Part II
Wall Street's Biggest Open Secret
Nothing in life is compulsory, but I suggest enjoying Part I first here:
The arc of this series is:
explain what Options are
explore what avenues for wealth building they provide
design income producing strategies and integrate them into a Wealth Engine — a subset of a broader Wealth System
In Part I we walked through Calls, Puts, Strike Prices, Expiration Dates and concepts downstream of those such as In-The-Money and Out-Of-The-Money.
Once we cleared vocabulary we explored the very basic mechanics of Options trading.
Part II will broaden and deepen those trading mechanics and explore the economics of various strategies.
This section we will begin discussing Option Selling vs Option Buying before exploring it much further in the Part III finale.
Trading Options Like a Professional
Recall that buying a call option gives you the right to purchase a stock at a specific price, known as the strike price, within a certain time frame. If the stock's market price exceeds the strike price, you can profit by buying at the lower strike price and selling at the market price.
Options are purchased for a price called a premium. An option's price (premium) generally combines its intrinsic value (profit if exercised immediately) and time value (potential for future profit).
Options have an expiration date. You must exercise your option before this date, or it becomes worthless.
Risk Hedge — #1 Wall Street Use for Options
Options provide the leveraged ability to buy/sell securities at fixed prices and times. You can control a large number of shares for a fraction of the cost of buying them outright.
This means that large financial institutions can “protect” a very substantial portion of their portfolio by purchasing calls/puts (depending on the price action they were attempting to mitigate) with outlay of a relatively small sum of Premium cash payments.
Yield Generator — #2 Wall Street Use for Options
Even though I place disclaimers on the bottom of any article that mentions financial matters, it should be repeated here especially: there is no such thing as a risk free investment, a sure-fire way to generate income that is 100% removed from risk of principal or non-payment of interest/royalty/distribution.
There are common strategies shared by hundreds of successful firms — and a major one in Options Selling.
The standard advice is: “Options trading can be risky. For buyers, the risk is limited to the premium paid, but sellers can face substantial risk.”
That is an accurate statement, but it isn’t complete.
While buying an Option makes you the owner of it, and gives you the power to exercise it… it absolutely obliges you to pay for that right.
Those Premiums are paid to the Option Seller, or Option Writer as they are sometimes called.
Put yourself into the mind of a financier for a moment, let’s play this out:
You run a small fortune on Wall Street.
You control portfolios of stock, and you want to create current income from the intermediate moves of the market, as your fortune rises with the marketplace overall.
You can sell Options and collect Premiums - every day if you wanted to.
When selling a Call, you’re betting the stock won't skyrocket. Selling a Put, betting it won't plummet.
Premiums are the key - the fee buyers pay. As the volatility / fear in the market increases, Premiums become more expensive.
Music to your ears.
It isn’t free cash. It never is:
If the stock skyrockets, I'm obligated to sell it cheap. Ouch.
If the stock nosedives, I must buy it at the much higher strike price. Double ouch.
It's about the strike price, where the deal gets real. Pick it wisely.
Expiration dates. The ticking clock. I need the stock to behave before time runs out.
Here's my mantra: Know the market. Feel the market. Be the market.
Options selling, it's not for the faint-hearted. It's for the bold, the calculated, the street-smart. The informed.
End Scene.
Was that fun?
Sometimes Options Selling really does feel like “free money”.
Other times it feels like ‘picking up pennies in front of the steam roller’ to quote an I-Banker friend of mine.
Can you do anything to slightly de-risk all that risk?
Rise of the Condors and Butterflies
My Grandpa was a very successful Manager at Metlife Insurance after serving (Honorably and like a Badass) before retiring in the late 1950’s.
His war buddy clients ended up being successful stock brokers, industrial leaders, real estate developers and other prominent trades and professions.
My Grandpa was their leader in the trenches and that never changed 50 years later.
After he retired he traded his stock accounts, began writing Options and learning a lot about managing wealth from Wall Street titans. They showed him methods to layer different Options contracts to reduce skyrocket/nosedive risk, and generate more predictable income.
He showed these to me as a kid, and they made little sense.
We discussed them briefly toward the end of his life, but he didn’t make sense unfortunately by that point.
Then I found his notebooks and journals when he passed and it all makes sense now.
Here are a few of the prominent ones I know are still very much practiced today:
Iron Condor: This strategy involves four different contracts. You sell one out-of-the-money put and buy another put with a lower strike price (put spread), and simultaneously sell one out-of-the-money call and buy another call with a higher strike price (call spread). The goal is to profit when the underlying asset stays within a specific price range.
Butterfly Spread: In a butterfly spread, you use three strike prices. You buy one in-the-money (or out-of-the-money) option, sell two at-the-money options, and buy one further out-of-the-money (or in-the-money) option. All options must have the same expiration date. This strategy targets a specific price at expiration, aiming for limited risk and potential profit.
Straddle: A straddle involves buying a call and a put option with the same strike price and expiration date. This strategy bets on the volatility of the underlying asset without predicting a specific direction. If the asset moves significantly in either direction, you could profit.
Strangle: Similar to a straddle, a strangle involves buying a call and a put option, but with different strike prices. The call's strike price is usually higher, and the put's strike price is usually lower than the current price of the underlying asset. This strategy costs less than a straddle but requires more significant movement in the asset's price to be profitable.
Is This a Secret Weapon?
That always depends on the wielder.
For instance, these multi-leg complicated trading structures can easily result in profit drain from trading fees and other friction.
Offset this by being smart by analyzing the fee structures of the Financial Advisors or Trading Platforms you utilize to Buy and Sell Options.
Pairing these strategies together can produce risk/reward payoff you are looking for.
I prefer to use Options to generate current income. There are several strategies that are modulated to that outcome.
These are my favorites, listed in ascending risk profile:
Covered Call: This strategy involves holding a long position in an underlying stock and selling a call option on the same stock. The goal is to generate income from the option premium. The risk is that if the stock price rises significantly, you might have to sell the stock at the strike price, missing out on potential gains.
Naked Put Writing: Here, you sell put options without owning the underlying stock. The idea is to generate income from the premiums, betting that the stock price will not fall below the strike price. If it does, you'll have to buy the stock at the strike price, which can be risky if the stock price falls significantly.
Credit Spread: This strategy involves selling options (either calls or puts) and buying further out-of-the-money options of the same type. The goal is to receive the net premium as income. There are two types: a Bull Put Spread (bullish) and a Bear Call Spread (bearish). The risk is limited to the difference between the strike prices minus the net premium received.
Short Strangle: This involves selling an out-of-the-money call and an out-of-the-money put on the same underlying asset with the same expiration date. The strategy is profitable if the stock price remains within a certain range, allowing you to keep the premium. However, it exposes you to potentially unlimited losses if the stock price moves significantly in either direction.
Attempting to write Options on stock you do not own requires a much greater “level” of account with your brokerage firm. They will ask you to fill-out several forms attesting your understanding of the risks involved, including the risk of total financial ruin.
That is for good reason.
But there is good reason the firms of Wall St continue to use Options as a pillar of their risk management and yield generation strategies.
Look Ahead to Part III
Now we’ve built our foundational understanding of Options and used that foundation to set-up more sophisticated tactics.
In Part III our final focus will be connecting these tactics together into systems, and mapping out hypothetical monthly + annual contributions to a Wealth System.
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