3 Situations When Stock Options Are Toxic
We write a lot about stock options here, and for good reason. When used widely, they can be a useful tool for adding to your returns.
We have detailed a number of strategies for using stock options even in conservative portfolios. You can use them to lower the price paid for a stock. They can add a few points to your returns even if the share price isn’t moving. Finally, we have detailed how to use options to add a bit to the price when you decide to sell your shares.
However, just as important as understanding when to use options is understanding when not to use them. Here are three cases.
1) You Need to Buy or Sell Quickly
Using options to buy at a cheaper price, or sell at a better price, can require patience. When you sell a put option in the hopes of acquiring shares, or sell a call option with the hope of selling shares, there are no assurances that the option will be exercised. Thus, it can take multiple attempts to execute the trade.
The good news is that each “failure” to execute results in you getting to keep the premium you earned when you sold the call or put. But if you need to trade quickly, forget about using options.
Even in the case of a short-duration option, you won’t get much of a premium and it still may not execute. Better to just directly buy or sell the stock.
2) You Don’t Want to Lock in a Loss
Sometimes when you sell a put, it will end up getting exercised at far below the current value of the stock. For example, consider a company trading at $110. You sell a put expiring in a month at a strike price of $100. But let’s say the share price has plunged and it’s trading at expiration at $70 a share.
At expiration, you will own shares worth $70. You will be sitting on a paper loss of $30 a share (minus the premium you received). Typically, when I acquire shares via a put, I turn around and sell a call against those shares. Not in this case. If I don’t think the outlook for the company will turn around soon — and especially if I think it’s going to get worse — I will sell my shares and take the loss.
However, if I think the downturn is temporary, I don’t want to lock in a loss. Selling a call against my shares would only be profitable if I sold a call with a strike price above $100 (minus any premiums received).
But if the strike price is far away from the current price, you aren’t likely to receive much of a premium for selling an option against your shares. In a case like this, I will usually just wait for shares to rise, and then make a decision on when and whether to sell the call.
3) The Dividend Beats the Premium
If you have an income portfolio of stocks with low volatility, you will generally find that the premium you can get for selling a call against your shares is pretty low.
I recently experienced a case where the premium I could get for selling a call against my shares of a 6% yielding stock was only worth about the value of the next dividend. In that case, I don’t want to give up shares for the value of one dividend payment. Don’t mess up a good income portfolio just for the sake of an option premium.
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