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Options Trading

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7min read
TL;DR: You can earn income on public stock you own that would otherwise sit idle by re-risking your position and selling what is called a “covered call.” This could be useful if you want to hold your stock for a long time but don’t expect a big price increase in the near term. Alternatively, you can also buy what’s called a “protective put” to de-risk your position, or you can combine the two strategies in what’s known as a “collar,” which limits both your downside and upside.

Congrats! Your company just went public and you now have a large amount of its stock. After working at your company for years, 99% of your net worth may be tied up in this one asset, which you may not want to sell just yet for various reasons. Maybe you don't like the current price and think the company will do very well and its price will go up in the future. There may also be tax reasons you don’t want to sell quite yet—for instance, you may still be under the 12-month long-term capital gains favorable tax treatment. So what else can you do?

There’s a way you can earn income or de-risk your position without doing much through something called "options trading". An option is the right to buy or sell an asset in the future. A call option is the right to BUY an asset by a certain date for a certain price, while a put option is the right to SELL an asset by a certain date (the expiration date) for a certain price (the strike price). Trading options can help in both generating income and in hedging against large losses.

Note: If you’re in a controlled position in the company, you may be restricted from trading. If you’ve left the company or you’re in a non-controlling position, you should be able to buy and sell options. If you are unsure, please ask your attorney before doing so.

How do I generate income on my stock options? 

As a concentrated stockholder, you can use covered calls to generate income, albeit with the understanding that you may have to sell the stock if the price dramatically rises.

Covered call selling (writing) may make sense if you’re bullish enough on your stock to want to continue holding it, but not so bullish that you anticipate a significant near-term increase in its price. Covered calls generate income (premium) in exchange for you committing to sell your stock if it reaches a certain strike price by the expiration date—usually 30 or 90 days in the future. All else being equal, 90-day call options generate more income than a 30-day call because there is more time and greater chance for the price to rise.

If the stock doesn't appreciate to the specified strike price by the expiration date, the option expires and you get to keep the stock and pocket the premium. At that point, you can then choose to write new call options with a later expiration date (“rolling” the position forward).

If the stock does appreciate to the strike price by the expiration date, you’ll have to sell your stock at the strike price.

For example, let’s say that you own 100 shares of a stock at a price of $250/share. You sell a call option that expires on June 1st that has a strike price of $275. Someone buys this option from you for $20/share. Come June 1st, if the stock closes below $275, your covered call expires “out-of-the-money.” This means that there is no value for an option to buy the stock at $275 when the stock can be bought at the open market for less. Therefore, the $20 you collected upfront is your profit to keep. With the option now expired, you can roll the position forward, do nothing, or sell your stock in the open market. 

But what happens if the stock appreciates to $275 or more on June 1st? Let’s say the stock is at $285. A buyer of that option could exercise or buy your stock from you at $275 and immediately sell it in the open market for a $10 profit. Your stock will get called away from you at $275 (vs. the $250 price when you wrote the option), netting you a $25/share profit + the $20/share premium from the original call option sale for a $45/share total gain. Keep in mind that you’ll lose out on any additional upside if the stock rises above $275 because you committed to selling your stock at that strike price.

So your potential payout would look like this:

Potential payout with and without a covered call limiting upside

If the stock price doesn't reach the $275 strike price, you would have a slight unrealized gain on the stock. Alternatively, if the stock falls below $250, you would have an unrealized loss. Either way, since you pocket the $10/share premium, you’re still better off than if you had done nothing.

An important thing to know is that options are priced as a function of the volatility of the stock. The greater the volatility of stock, the higher the premium you can realize (e.g. Coinbase > Apple). For more volatile stocks, the potential income generated from writing an option can be anywhere from 2-4% per month – more or less with lower or higher strike prices, respectively. 

Remember, the stock price could go down, up, or stay flat. You have to be willing to lose that potential upside if the price skyrockets and you’re forced to sell at the strike price. If you’re super bullish in the near-term, you should just hold the stock. If you’re super bearish, then you should probably sell now or buy a put which we will explain next. 

At Compound, we will implement your strategy for you. Your Financial Advisor and Compound’s Portfolio Manager will analyze your liquidity requirements, upside/downside tolerance, tax implications in coordination with your Tax Advisor, along with the options market price and volume dynamics, to recommend a strategy to execute on your behalf. Please contact your Financial Advisor if you’d like to learn more.

Hedging with Protective Puts and Collars

We discussed selling the opportunity cost of a stock price going up, but what if it crashes? While writing a covered call can help generate income, hedging can help de-risk a position (at a cost). Two types of hedging are protective puts and collars.

Protective Puts

The exact opposite of writing a covered call is buying a put for risk protection.

Protective puts allow you to buy the right to SELL a stock at a given strike price by a certain expiration date. This ability to sell at the strike price gives you a degree of certainty about a “worst-case” scenario, which can be triggered if the stock falls below a given strike price. This essentially makes it a form of insurance coverage, where you pay a premium for more certainty.

Take the earlier example, but say you bought a protective put instead. You buy a put option that expires on June 1st with a strike price of $225. This costs you $20/share. If the stock price stays above $225, your protective put expires out-of-the-money and you lose the $20/share you paid upfront, but you still benefit from any appreciation of the stock. 

But let’s say the stock falls to $200 on June 1st. You could then exercise your right to sell your stock at $225 even though the market price is much lower, saving $25/share in avoided losses. This has to be considered in addition to the $20/share premium you paid upfront for a $5/share total benefit from the position. 

With the put limiting your downside, your potential payout would look like this:

Potential outcome with and without a protective put limiting downside
Collars

A collar combines both covered call writing and protective put buying. This essentially takes the risk of ownership of the stock off the table. 

So if you used a collar ($200 put + $250 call) when the current stock price was $225, the potential payout would look like this:

This strategy can be beneficial if you would like to set a defined range (max and min) at which you would be willing to sell your shares. (Note: the collar strike prices have to be set at least 30% apart.)

There are important tax consequences to this position and you should consult with your Tax Advisor before implementing this strategy.

Bottom Line

If you’re comfortable selling your shares at a given strike price, writing options can offer a great means of earning income on an asset that would otherwise sit idle while you wait to sell your shares (though it may generate additional tax obligations). If you’re bearish on a stock in the near-term or looking to de-risk your position, protective puts or a collar strategy may make sense for you to minimize losses. Either way, options trading offers ways to make money on your stock and protect yourself from price drops.

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