Don’t Place That Call
AN ANCIENT FINANCIAL concept is gaining newfound popularity.
In his book Politics, Aristotle related a story about a fellow philosopher named Thales, who lived about 2,600 years ago. One winter, Thales made a prediction about the coming olive harvest. He felt that it was going to be a strong year. But because recent harvests had been weak, most people disagreed with him. To Thales, this meant opportunity. He approached the owners of olive presses in his town with a proposition. He offered them a small payment over the winter in exchange for the right to use their presses in the spring if the harvest turned out as he expected.
Thales was right, and he ended up making a fortune. Perhaps more important, with his payments to the olive press owners, he invented a new financial concept, now known as an option. Today, options exist across the financial world, and investment funds that employ options have been growing in popularity. According to the investment manager BlackRock, these sorts of funds have ballooned 20-fold over the past five years. But are they right for you? To answer this question, let’s first take a closer look at how options work.
The option Thales created was what’s now known as a call. It conveys the right—but not the obligation—to make a purchase at an agreed-upon price at a future date. Call options are the first and most common type of option.
Today, a second type of option exists. A put is the opposite of a call, giving the owner the right to sell an asset at a particular price at a future date.
How do options work in practice?
Call options are useful to investors who expect the price of an asset to rise. Consider Apple shares, which are trading at around $220. Suppose you think they’ll rise by year-end. You could buy a call option today with a “strike price” of $250 and an expiration date of Dec. 20. That would give you the right to purchase the stock at $250 at any point before Dec. 20.
Then, if the stock rises just a bit above $250, you’ll have a profit. That’s because the cost for an option like this is modest. Today, they’re trading at just 70 cents per share. This tiny cost is a reason options are popular with some investors. It requires far less capital to bet on a stock using a call option than by purchasing the stock itself.
A put option, on the other hand, could be useful to an investor who believes that a stock is at risk of falling. Consider Apple again. If you’re an Apple shareholder and worried the price might fall, one solution would be to buy a put option with a strike price of, say, $200. Then, no matter how low the stock fell, you’d be able to sell your shares at $200. In this way, put options are like portfolio insurance.
So far, we’ve looked at the benefits of buying options. But investors can also sell options. How would that work? Suppose you owned a stock and wanted to generate some extra income. You could sell call options on that stock to other investors. Continuing with the Apple example, if December call options with a strike price of $250 would cost 70 cents, you could sell those options and collect 70 cents per share. If the stock didn’t get above $250 before Dec. 20, you’d come out ahead.
Similarly, you could sell put options. In this case, you’d also collect a payment. In exchange, you’d agree to buy the stock from the option’s owner if its share price fell below a given price. This type of option is appealing to some investors because, in addition to the upfront payment, it’s a mechanism to buy stocks only when their prices fall.
Those are the benefits of options. But they aren’t without risks. For starters, all options have expiration dates, so if you’re buying either a put or a call, the benefits they confer will be temporary. If the stock doesn’t move in the expected direction, the option will expire worthless. This makes it easy to lose 100% of your investment.
If you’re the seller of an option, you face other risks. Suppose you own Apple shares and sell call options to generate extra income. If the price rises above the option’s strike price, your stock would be “called away.” In other words, you’d be forced to sell it. For that reason, selling a call means your potential gain on a stock will be capped.
Selling a put, on the other hand, means you’ll be obligated to buy a stock if its price drops. That can be a benefit since, all things being equal, buying a stock at a lower price is better than buying it at a higher price. But if something has gone wrong with a company—think Enron, for example—you might not want to buy the stock at any price.
These strategies have been around for a long time. But in recent years, a growing number of funds have started to incorporate options. These funds go by a variety of names, the most common of which is a “buffer” fund. The objective is to deliver results that are less volatile than the overall market—with less upside potential but also less downside risk.
The most common buffer funds employ a three-part formula. First, they buy exposure to an index such as the S&P 500. That provides upside potential. Then they buy put options on that same index, which limits downside risk. Finally, they sell call options on the index. This helps pay for the purchase of the put options, but in exchange for that, the fund’s growth potential will be capped.
In theory, this is a good structure, offering a less volatile way to invest in the stock market. There are, however, three challenges with funds like this. First is cost. The most popular buffer fund, the First Trust Vest Laddered Buffer ETF (symbol: BUFR), carries an expense ratio of 0.95%. For comparison, a standard S&P 500-index fund typically costs less than 0.05%.
Another challenge is complexity. Visit the BUFR website, and you’ll find a dense page of numbers that only an options expert would understand. On the website for its line of buffer funds, iShares includes this disclaimer: “The Buffer and Cap apply to Fund shares held over the hedge period. An investor that purchases Fund shares after the beginning of a hedge period, or sells Fund shares before the end of a hedge period, may not fully realize the Buffer or Cap for the hedge period and may be exposed to greater risk of loss.” Standard investment funds don’t need disclaimers like this.
This gets at the final risk with buffer funds. None of them has a long track record, so they may not perform as expected. Robert Merton is an academic who’s well known as one of the creators of the widely used options pricing formula known as Black-Scholes-Merton.
And yet, in an interview for the book In Pursuit of the Perfect Portfolio, this is what Merton had to say about complex financial instruments: “When I say I have a model, it’s a model of what should happen or what is expected to happen.” But Merton adds, “The model has an error term. It shouldn’t be there, but since no model is complete, you always have an error.” Options-based strategies, in other words, may or may not work out as expected.
This is the most important reason I’d avoid funds like these, and instead opt for simpler investments. Investment markets, in my view, are unpredictable enough without introducing the “error term” that Merton knows is unavoidable.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam's Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.The post Don’t Place That Call appeared first on HumbleDollar.
