Derivatives often get a very bad name from many investors. When derivatives are used properly they can leverage and magnify your returns however, when used improperly, they can really magnify your losses as well. They are high risk, high reward investments which are not for the faint of heart. And you definitely need to know what you’re doing.
Warren Buffett has said that derivatives are “financial weapons of mass destruction”, and if we look back in history, we can see the damage they’ve done. The largest single day crash ever on Wall Street was Black Monday in 1987 and that crash was largely called by a new type of derivative product called portfolio insurance which went haywire and eventually crashed the whole market. And of course everyone knows the horrible crash in 2008 and 2009 which first originated in mortgage backed securities but was greatly enflamed by derivative products on those same mortgage backed securities. More recently I’ve noted that a number of amateurs are getting into options in a big way, sometimes with disastrous results. One of the things about options is that you can sometimes lose more money than you put into it, which is a concept that new options investors don’t always grasp. That’s how a 20 year old trader racked up hundreds of thousands of dollars of losses, even though his own account never had anywhere close to that level of money in it. Tragically he took his own life over his mistake. https://www.cnbc.com/2020/06/18/young-trader-dies-by-suicide-after-thinking-he-racked-up-big-losses-on-robinhood.html. While that case may be extreme, it is not unusual, as options can wreak havoc when you don’t know what you’re doing.
If you’re still interested in options, even after my warnings above, then read on. I do think there are ways to intelligently incorporate options into your portfolio if you are careful and you fully understand what you are buying. One of these ways is through what Joel Greenblatt calls LEAPS. LEAPS stands for Long Term Equity Anticipation Securities. Essentially a LEAPS is a long term call on the equity securities of a company you expect to appreciate in value.
Before we get into the weeds here, let’s start with the basics. What is a call option? A call option is the right to buy a stock at some future date at a specified price which is called the strike price. The option holder has the right, but not the obligation, to buy a stock for a limited period of time. All call options have an expiry date. There are many public companies whose options are publicly traded all the time and are available to virtually any investor.
In order to understand call options, here is a simple example. Let’s say the stock of Berkshire Hathaway is trading at $200 per class B share and I think the fair value is worth $250 a share. If I expect the stock to eventually go up to my price, I could buy the stock and wait for it to rise to my price. In a year’s time, when the stock rises to $250, I’d sell and make a cool 20% on my money and I will be happy.
On the other hand, I could also buy a call option with a strike price of $200 which will expire in 2 years. For this call option I will pay a $25 premium. That $25 premium is all of the money I have to invest, whereas if I bought the stock, I would have to invest the full $200. With my call option, when the stock rises to $250, my option will now have a value of $50 when I sell it. That’s because the option I have is to buy the stock for $200 when it is actually trading at $250. I could exercise my option, buy the stock and sell it immediately netting me a $25 profit ($50 profit on the sale of the stock minus the $25 premium cost). Since I only invested the $25 premium, my return on my investment is 100% ($25 profit on a $25 investment). I’ve doubled my investment in one year!
This is not without risk of course. If the stock price goes down instead of up, and goes below my $200 strike price of my call, then my option could expire worthless and I will lose my entire investment of $25. The fact that the option has a time limit also means that I have to be right about the company I’m investing in, AND I have to be right about the timing. In order to minimize this risk, I usually try to buy the longest dated call options possible. I also stick to securities where I have a high conviction that the stock will rise in the short term.
While this is certainly risky and not for amateurs, I think measured use of LEAPS can greatly enhance a portfolio’s returns. I’ll give you an example from one of our own clients. In 2019 Alibaba Group Holdings’ (BABA) stock price had been impacted by the trade war and was trading at around $170 USD per share. At that time you could buy a call option with a strike price of $170 which would mature in June of 2021. The premium cost of that call option was approximately $33 an option. We did not expect the trade war to have much of an actual impact on Alibaba’s business and therefore we believed the price was likely to bounce back quickly. The stock has since risen as we expected to a price of approximately $251 a share at today’s close. The market price of our call options is currently $93.50 an option. Had we bought the stock, our return would have been 47.65% in one year, which is nothing to be upset about. But because we bought a call option instead, we are actually up 183% or almost 4 times as much over the same time.
What’s also important to note is that we only ever risked $33 a share whereas if we had bought the stock, we would have had to put $170 at risk. If the stock had continued to tank, the potential loss on the stock could have been much more than the $33 we paid for the option. While we obviously felt that was unlikely in the case of Alibaba, it is still an advantage of using a call option as opposed to buying the stock.
The leverage used in options is something which investors need to be careful about. However, with proper positioning and selection, they can be a very positive addition to a portfolio. If you are curious about whether options would be right for you, I would encourage you to reach out to an Endeavour Wealth Management Investment Advisor to discuss.
- Craig White, BA, LL.B., CIM®
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.