The stock markets have not been easy for investors since the beginning of the year. Stocks had their worst first half-year run in 52 years given the fears of the Russia-Ukraine war, high oil prices, the never-ending pandemic, as well as inflation and recession worries. The stock market volatilities were constantly at a high level over the past few months.
If you are a rational investor, you know that the stock market will eventually come back. But the question is: “How can you protect your portfolio and yet not miss the opportunities?” After all, nobody wants to see their portfolio bleeding. But moving in and out of market in a volatile market can be suicidal.
In this article, I will show you an example of how you can use “option derivatives” to enhance the risk-return of your portfolio.
I know, the word “derivative” sounds scary. Because in the mainstream media, this type of instrument is always associated with “disaster”. After all, derivatives were blamed for the Global Financial Crisis and Warren Buffett famously said that derivatives are “financial weapons of mass destruction”.
So, if you are not comfortable, you can skip this article entirely.
Otherwise, please continue reading.
Disclaimer: Note this article and any examples used are for education purposes. It is NOT financial advice. As the article is meant for beginner investors, I will skip some technical details and concepts. If you feel lost by reading the article, it is ok. It simply means you should spend more effort studying the instruments before jumping onto the wagon.
While a lot of people speculate using derivatives and suffer big losses, derivatives can be useful tools to be used as a hedge. And that is what they were originally created for.
Professional investors and commercial traders use complex derivative structures to “manage” their risk exposures, but there are some simple strategies we as retail investors can adopt to enhance our stock portfolios.
What is a derivative?
A financial instrument is considered a derivative if its price depends on (or is derived from) another asset. It often involves a contract or agreement where parties are either obligated to execute trades or have the right to do so under certain conditions.
Even though derivatives seem like complicated instruments, they are quite handy if you know what you are doing. They can be used to limit your losses in the case of bad investments or generate additional income for your stocks.
Derivatives used to be a big boys’ weapon to hedge their financial positions and were only offered to rich clients. Luckily, with recent technological advancements, retail investors can now easily access them through the use of online brokerages such as Tiger Brokers (I will later use screenshots from Tiger Broker’s platform to illustrate some examples).
I will start with a simple options strategy which is easy to start. Understanding how basic options work can be very useful for anyone who is inspired to long-term investing success.
What is an Option?
An option contract gives the buyer the right but not the obligation to buy or sell the underlying asset by a particular date (expiration date) at a particular price (strike price). Options fall into two main categories:
- Call option: A call option grants the buyer the right but not the obligation to purchase (buy) the underlying asset at the set strike price.
- Put Option: A put option grants the buyer the right but not the obligation to sell the underlying asset at the set strike price.
Next, I will explain the “covered call” option strategy which can be handy in today’s market given the high volatility.
What is a “Covered Call” option strategy?
Here, I am going to give you an example of how selling a call option on a stock that you already own can improve your portfolio. This strategy is known as a “Covered Call” and is commonly used by many fund managers. It is “covered” because you already own the shares required to execute the contract.
Let me give you an example.
Let’s assume you own 100 shares of Tesla (TSLA), which you purchased at $950. Unfortunately for you, Tesla’s share price closed at $901.76 as of August 2, 2022, and therefore you are at a loss.
Now you are worried about the market and just want to get out as long as you break even (though this is a wrong mentality, I will discuss it as another day’s topic). You have two options:
- Put a limit order to sell Tesla at $950, or
- Sell a Call Option with a strike price of $950.
Why do we want to do the latter?
What does selling a Call Option mean?
It allows the purchaser of that option to buy the 100 shares at a strike price of $950 from you. In exchange, the buyer of your option will pay you a premium.
You can think about it as an insurance contract, the buyer pays a premium to the insurer and in the event that something happens (Tesla goes up to $950), the buyer can claim the Tesla share from you. And you are the insurer.
You may well ask, “Why would someone want to buy Tesla at $950 when it is only $900 now?” Because that person may be bullish on the Tesla stock but unwilling to take the downside risks. So they buy an option to limit their loss to the option premium which they pay to you.
What is your risk? Your risk is losing your Tesla share to the buyer at $950 and worse, the share price goes “to the moon”. But since you already decided to sell Tesla shares at $950, and if you were to put a limit price at $950, you would have sold at this price anyway.
So how much premium can you collect? I will use Tiger Broker’s platform to show you how to do it. The steps should be similar to any other online broker you use.
With the Tiger Broker platform, click on the Options next to the Stock Ticker.
You will be led to the Option Table.
If you see this option table for the first time, it can be a bit overwhelming, so I highlighted the important fields for you.
If we look at the option with the expiration date of August 19, it is 18 days from today. And the last done Call Option premium with a $950 strike is $25.57.
For every 1 option, the value is derived from 100 shares. What this means is that if you sell one Tesla Call Option with the expiration date of August 18 and strike price of $950, you will receive a premium of $25.57 * 100 = $2,557 (excluding commission and other fees which is about $3+ in this case at Tiger Broker).
I must emphasize that it is super important to “preview” the transaction after you click the red button.
Tiger Broker has recently enhanced its system to give you a clearer picture of the portfolio impact analysis before you place the trade.
The preview will show the change of Margin requirement and impact on Liquidity before you place the trade, which is super useful in my opinion.
How does the Covered Call help the portfolio?
Why do we go through all this trouble?
Well, let’s analyze this. There are a few scenarios that can occur by the options expiration date of August 19. (The calculations shown below ignore the commission and fees):
- Tesla share price does not reach $950 – If the contract expires and the option is not exercised, you get to keep the $2,557 premium. You are better off compared to if you did nothing.
- Tesla shares price just passes $950 – Your Tesla share will be “called away”, but you still get to keep the $2,557 premium. And you are $2,557 in profit compared to the breakeven scenario if you were to limit selling Tesla stocks at $950.
- Tesla share goes way beyond $950 and shoots to the moon – You only have a profit of $2,557 and won’t participate in the upside of the share price.
So, at a glance, you are better off in the first scenario, but lose the upside in the third scenario. But this is what derivatives and any other investments are about, you can’t win them all.
A word of caution
The use of derivatives carries huge risks if you don’t know what you’re doing because they are leveraged items. For example, if you don’t already own a Tesla share, you will be “naked selling” and if the share prices go up quickly, you may lose a substantial amount of money.
Another thing is that if you don’t manage your leverage well, you may encounter a “margin call”. And your position will be forced sold.
You can read this link from Investopedia for a better understanding of the risk of covered calls.
So, learning and practising are the keys for you to improve your trading. One of the good platforms to learn and trade derivatives that I recommend is Tiger Broker. The derivatives available on the platforms are:
- US options
- Hong Kong options
- Hong Kong Warrants & CBBCs (Callable Bull/Bear Contracts)
- Equity Indices
- Precious Metals
Right now, Tiger Brokers are running a zero-commission campaign on SG, HK & US stocks and CN A-shares. So do check it out.
- 365 Days of unlimited commission-free trades for HK, SG and China A stocks and
- 180 Days of unlimited trades for U.S stocks.
You must be wondering, what does the broker earn if the commission is zero? That is a good question, and I asked the same.
As far as I know, Tiger Brokers does not do these. Instead, they really leverage their next-generation technology to keep the cost low for the users. And of course, they also earn through cross-selling other products such as futures, options, funds and margin financing, etc.
Disclaimer: This post is sponsored by Tiger Brokers, T&Cs apply. Please visit their website for other applicable fees. This advertisement has not been reviewed by the Monetary Authority of Singapore.
Let me summarize…
Derivatives can be incredibly useful in the hands of a person who knows how to use them effectively for portfolio management.
Learning the most effective ways to use Options can be a huge project and we have just touched the tip of the iceberg. The learning curve can be steep but I believe it can significantly improve your investment returns if you master it.
Although this is a brief introduction, I hope it helps you see more investing opportunities. There has never been a better time to make use of all the latest technology and tools that were previously only available to advanced investors and institutions.
There is another breed of derivative called futures, which is an effective tool to increase the risk/return of your investments.
Additional Reading: How to use futures contracts to hedge portfolio risks.
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