The Truth About Options

Honest Tales Of An Options Investor

IMPORTANT: If You Are New To Options, Take Some Time To Learn About Options So That This Article Is Relevant To You.

Do you invest with options?
It is one of the most popular financial derivative tools available today. We all heard of the tales from our friends, families and neighbours about the fortune they made using it. Maybe some of these lines will help ring a bell:

“You can sell options every month and collect 5% per month!”
“You can collect $500 a month by sell options! That’s FREE money every month!”
“If you bought the stock, your returns are 50%. But if you bought a call, your returns are 150%!”
“With only $100 of capital, you can make up to $1,000 in profits!”
“I can invest with $0 capital and make $5,000! My ROI is infinite!”

In fact, these are some of the favourite lines of many financial gurus who sell option courses. It is definitely tempting that you can use options to generate money every month to pay for the course fees, making the courses you join literally free.

I don’t disagree with it.

But that is just like saying that anyone can make a perfect pizza. However, what I believe should also be disclosed are the ingredients, tools and methods to make the perfect pizza. You may be inspired to make the perfect pizza initially. But would be equally inspired if you knew that one of the secrets is to have a pizza oven that costs $3,000?

In this article, my aim is to share with you what I believe are the ingredients, tools and methods to be successful with options so that you can use it only when you are ready. I have seen how powerful it is and at the same time, I have seen how destructive it can also be. I know many friends who made a fortune with them and I also know friends lost almost their entire portfolio due to options. Because of that, I believe transparency is needed.

Firstly, Do You Really Need Options To Improve Your Portfolio Returns?

The simple answer - No.

I must first clarify that I separate my stocks and options portfolio. Below is my core portfolio’s Year-To-Date’s performance for the year 2021. Apart from the phenomenal returns I managed to achieve in 2020, my entire portfolio managed to grow by another 73% in 2021. Remember, this is done entirely without options. Just the right investment strategies and framework.

I do know some of my friends whose portfolio performed better than me because of options but only because they are operating under the right conditions.

So What Are The Right Conditions?

There are basically 3 traits I found that are needed to give you some degree of success with options. Here are the traits/characteristics you need:

1. Portfolio Size > US$ 25,000
   

2. The Right Investment Objective/Strategy
   

3. Good Investment & Market Experience

Portfolio Size > US$ 25,000

I remembered I was very excited when I was first exposed to the idea of selling options. I remembered my coach was sharing with me back then, if Facebook is trading at $160 a share, I can sell a put option to buy it at a lower price like $140 and collect 2-3% in option premiums every month. Its like a no brainer: I get to collect money and at the same time if the option contract gets exercised, buy it at a price lower than its current market price. I was so happy. I started planning holidays, how much to give my parents etc. But that was until I realized that the minimum number of shares for an option contract is 100 shares!

That means if I wanted to pocket the 2-3% premiums by selling a put option to buy Facebook at $140, I would need to set aside $14,000 to buy the shares. If I had a portfolio size of $15,000 for example, that would mean that I have to allocate 93.3% of my portfolio for a single stock. To allocate that percentage of my portfolio to Facebook alone means that I must know the company more than Mark Zuckerberg and have a conviction stronger than Adamantium.

What if I were to buy a call option instead? Back then, a call option on Facebook would cost me $30 each - Except again, that is per share. Every option contract requires you to pay for 100 shares. So my total investment would be $3,000. Now on a $15,000 portfolio, allocating 20% to Facebook is not a bad idea. If the stock price falls by 20%, I can always wait for many years for the stock price to recover and profit as the company improves its fundamentals.

But I then realized that with a call option, I can lose up to 100% of my capital if the stock price simply stays flat during the entire duration of the contract. Of course you can also lose 100% of your investment in a stock, but how often does that happen? Most of the time you lose 20, 30 or even 50% of your capital if you are wrong. But when you buy options, losing close to 100% of your capital happens more often that you think! With that info, suddenly risking 20% of your portfolio does not make sense even if the stock is a high quality stock like Facebook - because we can never know what will happen within such a short period of time.

Let me show you an example of one of my most painful losses using options. In July 2018, I bought a 1.5 year call option on JD.com because I believed it to be the next Amazon in China and its stock price will go up.

To my disappointment, it simply stayed flat. If I held the stock, I would breakeven on my investment. But since I bought a call option, I am looking at an 86% loss of capital. Losing $1,300 may not seem like a lot for most people. But it was a lot for me because my portfolio size was only US$ 3,700 and I don’t have anymore to put in. In simpler words, 35% of my wealth just vanished within 1.5 years.

The most painful part was that my investment thesis was right. The stock did go up eventually. But I couldn’t enjoy the upside because my call options expired.

So why do you need a huge portfolio size?

Simple, because to sell puts, you need to put up a huge collateral in case the option gets exercised and when you buy call options have an underlying risk if losing 100% of your capital, meaning you only want to risk a very small portion of your portfolio on call options.

So why at least US$ 25,000? Because most companies listed in the US, especially those with good option liquidity trades at a minimum of US$ 50 a share (based on experience and observation). Meaning that if you sell a put option, you need to set aside collateral of US$ 5,000. Compare to a capital size of US$ 25,000, that is a 20% sizing. Of course, the larger the capital, the easier it is for you to sell put options. You will not be pressured to look purely for stocks that are priced cheaply. You can focus on doing the due diligence on the stock before selling the option. And also, that US$25,000 has to be in idle cash. NOT total portfolio value.

However, even though my core portfolio’s value is multiple times bigger than US$25,000 now. I still rarely use options in it for the 2nd reason which I am about to share with you:

The Right Investment Objective/Strategy

Every portfolio needs to have an investment objective. Without an objective is like flying a plane without knowing your destination and without a radar.

Remember this phrase some of your friends used to tell you?

“Just sell options monthly and collect 2 - 5% per month. That’s 24 - 60% FREE MONEY per year!”

When I hear that, I would immediately say in my head:

This is like telling someone there is a magical bucket at the end of the rainbow that can give you cash whenever you ask for it but without telling them that they have to first fulfil the “12 labours of Hercules” to get to it. I have spent countless hours answering questions from many readers on how to fix various issues with their portfolios after they went trigger happy selling put options thinking that it was FREE MONEY. Always remember something: NOTHING WILL EVER COME EASY. There is always a trade off.

P/S: If you want to ask me questions, feel free to ask me on social media. Just try not to abuse it :)

First, let’s clarify the 2-5% returns per month.

In 2017, I sold a 1 month put option on Gentex at a strike price of $17.50 and collected 2.00% in premiums. Back then, I thought it was a good deal. Gentex sells specialised electrochromic rearview mirrors for cars and commands up to 90% global market share. $17.50 was a very good price to buy the shares in my view back then. So if my put options gets exercised, I am very happy to buy 100 shares at $17.50 each. Plus I am getting a 2% premium per month while waiting to buy 100 shares of GNTX at $17.50 each. Sounds like a perfect deal right?

When I look at Gentex today, I don’t think so. I knew the company was growing. I knew the company would do well. And the worst part, I was right. Today the stock is more than double its value compared when I found it in 2017.

If I had bought the stock directly instead, I would have made a 116% return over 4 years on the stock. Instead, I have only made a 2% return over 4 years by collecting the premiums. And because Gentex has gone up so much. If I wanted to sell the same put option at strike price of $17.50 again, the premiums I can collect is literally $0.

So it is NOT a 2.00% per month return. Instead, it is a ONE-TIME 2.00% return. To collect this 2.00%, I forego a 116% return. The worst part was, after all the hard work talking to the management, reading up tonnes of industry reports and weeks of following the company, my investment thesis was correct! And for all that hard work, I was rewarded with a measly 2.00% return.

I then realized that the only way I can collect premiums every month, is to sell put options on different stocks every month. That means that I need to have a huge watchlist of stocks that I have done due diligence and have strong conviction on. My question to myself back then is, do I have such a watchlist? The answer is an obviously no.

Next, let’s talk about it being “Free Money”.

Around 2017 to 2018, I have a bunch of friends who are consistently sold monthly puts on this particular ETF called NUGT. They were doing it very diligently because they can collect between 6% to 8% per month worth of premiums every month. Even today, if you choose to sell a 34 day put on NUGT at strike 51 (Market Price), you can collect $3.15 worth of premiums. That is about 6% premiums for 1 month.

They called it “Free Money” and laughed at me for ignoring such an easy opportunity. Unfortunately, their put options on NUGT got exercised and they were forced to buy the shares at about $200 each (Price After Consolidation). Today, each share of NUGT is worth only about $50. This means that they have lost about 75% of their capital by selling puts on this stock.

In fact I have seen the same thing happening over and over and over again. People messaging me that their put options got exercised and they are forced to buy the shares at a higher strike price and what they should do. I will always ask them if they want the stock. The most common answer I get is - NO.

All these experiences taught me a very valuable lesson. Option premiums are NOT FREE MONEY. They are payments for obligations that you potentially have to fulfil. If the obligation is going to harm you, why take the money and risk having to do it?

Personally, I use options only for 2 different investment strategies:

1. Prioritizing Cash Flow Over Capital Gains

I will deploy this strategy once I have generated enough capital gains. In other words, I reached a stage in my life where it is more sensible to be conservative rather than aggressively investing for portfolio growth. I will then prioritize safety over growth by focusing on selling put options rather than buying the stocks directly. The good thing about selling puts is that I can choose the stock I want, and select strike prices that I am very comfortable with and collect premiums. If I hold stocks, I can also sell call options at a very high strike price and pocket the premiums. This modus operandi is similar to that of an insurance company. They collect the premiums only when they know the underlying risk is very low.

The returns by doing this can allow me to generate way better returns than to actually buy into a dividend company. However, you need a really large portfolio to do it (More than US$ 250,000).

2. Asymmetrical Returns Opportunity

I learnt and designed my strategy on asymmetrical returns after I watched the movie ‘The Big Short’ for more than 30 times. It is simply a strategy whereby if you are wrong, you are wrong small. But if you are right, you are right big. Something like the lottery. A small bet of just $10 can potentially win you a cash prize of $1 million. The problem with the lottery is that there is literally no way for you to estimate the outcome and you have very little time (Less than a day) to get it right. So the odds are heavily stacked against you.

Stocks, on the other hand, can be analyzed and you can make deductions. You also have more time (Up to 3 years) to let your investment thesis play out. This makes asymmetric investment opportunities available. When such opportunities arrive, I would buy call options using a very small % of my portfolio. That way if I am wrong, and face a 100% loss, it wouldn’t bother me much. But if I am right, my portfolio will explode in value very quickly.

The only downside of this strategy is that opportunities do not surface often. The last time I manage to grab such opportunity was when I came across Gamestop when it was trading at $9 a share. I managed to buy multiple out-of-the-money (OTM) call options on it and later saw my portfolio value increase by 8x when the short squeeze saga unfolded.

Good Investment & Market Experience

Upon reflecting, I realized one of the biggest reasons why I failed to achieve good results with options in the past was because I lack a strong valuation framework, research process and emotional stability. I used technical indicators most of the time to decide my entry and exit and that is the biggest mistake. Not because the technical indicators are not working. But because it failed to give me the conviction I needed.

Today, I firmly believe that if I want to do well with options, I need a very strong investment thesis and valuation framework to back me up. A good test to know if you have these qualities is to observe your own behaviour. If you find yourself always asking others what is their valuation of the company before you have the courage to execute your trades, then you lack a framework. With a strong framework today, I can decide my entry and exit very confidently. I can also know what to do next if the share price goes down. And most importantly, I can do it with confidence.

I understand when to hold, when to add more position and when to cut off bad investments. I know how to differentiate between market noise and fundamental threats to the company. When I sell a put, I know what strike price to pick and I know exactly why I am very confident that I can make money by selecting that strike price. And that is the game changer. Of course, if you are an expert with technical indicators and are consistently right with them, then you can say that you have very good market experience as well.

In Conclusion

Options are an interesting tool. It can amplify your returns in the stock market. But use it wrongly, it can also amplify your losses. If you are not experienced in dealing with the beast that is the stock market, investing with options directly is like diving in a tank infested with hungry sharks without a cage or body armour. You are simply waiting to be eaten alive.

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