When I’m asked for investment advice and I say “nobody knows what will happen to an individual stock,” I almost always get nodding agreement, but these same people then act as if they know what will happen to their favourite stock. In a recent case, I was asked for advice a year ago by an employee with stock options.  At the time I asked if the current value of the options was a lot of money to this person, and if so, I suggested selling some and diversifying.  He clearly didn’t want to sell, and he decided that the total amount at stake wasn’t really that much.  But what he was really doing was acting as though he had useful insight into the future of his employer’s stock. He proceeded to ask others for advice, clearly looking for a different answer from mine.  By continuing to ask others what they thought about the future of his employer’s stock, he was again contradicting his claimed agreement with “nobody knows what will happen to an individual stock.” Fast-forwa...

The obvious upside of naked puts is that you get to say “naked” without being inappropriate. However, they have downsides as well. A colleague of mine (let’s call him Jim) took the time to understand how naked puts work and reacted the way many people react: they seem like free money. I’ll explain what naked puts are and why they don’t give free money. Let’s use Jim’s example Bank of Nova Scotia stock (BNS). The buyer of a put option on BNS has the right, but not the obligation, to sell BNS shares at a set “strike” price to the seller of the put option. In Jim’s example, he could sell put options on BNS for $6.25 each. If the BNS shares drop, the option buyer could force Jim to buy BNS shares at the strike price of $66 any time until January. The “naked” part of a naked put refers to the fact that Jim does not have a short position in BNS shares that would be closed out if he is forced to buy the BNS shares. The way Jim sees it, he can’t lose. If he is forced to buy the BNS...

Rob Carrick reported that so far cover-call ETF results have been disappointing. Some investors have been surprised by this, but the real surprise is that so many seemed to expect outperformance. At its core, a covered-call strategy involves owning stocks and selling call options on those stocks. Compared to a strategy of just owning stocks, the difference is obviously the short position in call options. So, for a covered-call strategy to outperform, the excess profits would have to come from the options. For the options to be profitable, traders would have to consistently trade call options far above their real value. Why would anyone expect this to be the case for such short-term financial instruments? Even if writing covered calls has no expectation of excess profits, it is reasonable to expect that it will change the volatility of investment returns. But again, I see no reason to expect that we will be left with anything other than the usual relationship between risk and...

Savvy investors have a plan and stick to it. However, even positive events, such as receiving stock options from an employer, can disrupt their plans. Call options on a single stock are just not a part of most investors’ long-term investing approach. Here I investigate how incentive stock options fit with an index-based investing plan. One simple answer would be to exercise the options (if they are in the money) at the earliest opportunity and sell the received stock. However, there are cases where this clearly makes no sense. For example, if you have 1000 options struck at $10, and the stock trades for $10.10, it makes no sense to cash out for only $100. Given the downside protection the options provide, it makes more sense to hold on. If the stock manages to get to $11, the value of the options increases 10-fold. Another answer is to go on the open market and sell call options on your employer’s stock. On paper, this gives you both the stock value above the strike price p...

Back in March the Conservative government announced some changes to the way that stock options are taxed . One of these changes brought relief for those who had to pay taxes on phantom income. Unfortunately, these new rules did not become law until Bill C-47 received Royal Assent December 15. Canada Revenue Agency (CRA) was quick to come out with a form to allow people to elect to pay a penalty tax instead of paying tax on the phantom income. This form has the catchy name Election for Special Relief for Tax Deferral Election on Employee Security Options. This whole business is quite complicated. If you’re affected, you may want to get some professional tax advice.

Stock options have a very poor reputation. They are thought to be either the magical lottery tickets that make CEOs even wealthier or as financial dynamite that can wipe out the savings of the little-guy investor in no time. Blogger Mark Wolfinger believes that stock options are misunderstood. He points to the many ways that options can be used to reduce the riskiness of investments. Wolfinger has devoted much effort to educating people about the smart ways to use options. Perhaps a different approach would have a better chance of success because stock options are likely to continue to be viewed as the toys of reckless traders. The problem is that there is a steady stream of people who do manage to lose their savings by trading options. They do this by taking wild chances that Wolfinger counsels against, but that is a subtle point in the battle over the reputation of stock options. The fact is that these bad experiences lead directly to the fear of stock options. I haven...

A while back I explained an unusual stock option-related situation where it is possible to buy and sell stock and end up owing more in taxes than the proceeds from the sale. The latest federal budget has remedied this situation by limiting the tax owed to the proceeds of the sale . However, this budget is not yet law. This brings me to the question of how reasonable CRA plans to be about this. I’m in a situation where I owe a very large sum under the current tax rules, but once the budget becomes law, I can refile my 2009 taxes to owe a much smaller sum. As the transition of the budget into law is largely a formality, it makes little sense to send CRA a lot of money only to get it back soon. After penetrating many levels into CRA’s help system, I was told that in fact I could just pay the lesser amount and my return would be held until the budget passes (as long as I file the return along with some special forms to ask for special treatment). This sounds very reasonable, but I...

The usual Friday feature of short takes will have to wait until Monday because the 2010 budget appears to have a provision to finally help people caught in a stock option trap. I’m in this situation along with people I used to work with at both Entrust and Nortel. Canadians generally think of stock options as financial lottery tickets given to CEOs and other company bigwigs to make them rich. There is a lot of truth to this. But during the technology boom in the late 1990s, even working level employees often received a few stock options not realizing their potential for financial harm. When stocks rise and employee stock options become valuable, we usually say that so-and-so “cashed in his options” and now the jerk is rich. However, this glosses over the fact that it is really a two-step process. For example, a Nortel employee first had to exercise the stock option by paying its strike price. Then the employee received Nortel shares and could sell them in the stock market for...

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy. Not to be too philosophical, but my experience has taught me that I’m best off to conduct myself as though there exists a single objective reality that applies to all of us rather than each of us having our own separate realities. What does this mean for the investing world? If several people all buy 100 shares of ABC stock at the same time for the same price, then they will all get the same return over a given period of time. Some of these people bought ABC stock for very smart reasons, and some might have bought it because they have the initials ABC. Some of the investors are smart, some dumb, some nice, and some mean, but they will all get the same return. This all seems obvious enough, but you have to keep it in mind when you read the come-ons for businesses that want to set you up with an account to trade stock options. Stock options are s...

Yesterday, I looked at how to protect a portfolio from a big drop in stock prices using put options , but the result was unsatisfactory. Mark Wolfinger left a comment suggesting selling a call option as well to create what is called a “collar.” This may sound complex, but the effect of a collar is simple enough. Your stock market returns are limited to a range. If stock losses are too deep, the purchased put options compensate you to limit your losses. If stock market returns are very high, the call options you sell limit your gains. You may wonder why anyone would bother with the call option part if they limit your gains. The answer is that you get cash from selling the call options that you can use to buy the put options. So, in trade for the guarantee that you won’t lose too much, your gains are limited as well. The particular strike prices of the options are what determine the limits on gains and losses. Of course, we prefer a tight limit on losses and a generous limit...

For investors who can’t stomach the volatility of investing 100% of their long-term savings in stocks, the usual advice is to put some fraction of savings into fixed income investments. Another approach is to use stock options to protect against large losses. Suppose that an investor Irene has $100,000 that she wishes to invest mostly in large U.S. stocks, but is nervous about losing money. One approach for Irene is to just put all of her savings into the S&P 500 (which is sitting at 900.80 as I write this) and live with the volatility. The following chart shows the returns for Irene across a range of possible outcomes in the S&P 500. We’ll focus on her results as of June 2010, a little over a year from now. It’s the lower left hand corner of this chart that worries Irene. The thought of losing that much money is scary. One solution is for Irene to put some money (say 30%) into fixed-income investments. The following chart compares the all-stock approach to the 70...

Last week I showed that the frictional costs of commissions and spreads are higher with stock options than they are with trading stocks . Reader feedback included Mark Wolfinger’s comment that I hadn’t accounted for interest on cash not tied up when investing with options, and Glenn’s comment that option spreads are more reasonable in the U.S. So, let’s do the accounting a little differently and see how it affects the results. The original scenario was to compare direct ownership of 200 shares of RIM to a stock option-based synthetic version of RIM stock ownership where we buy 200 call options at the money and simultaneously sell short 200 put options at the money. This time let’s assume that the market gets the option pricing right to account for the interest on cash that gets tied up with stock ownership but isn’t tied up with the synthetic stock option version. We can calculate the friction costs by simply assuming that each trade loses half the bid-ask spread plus whatever c...

Stock options are often demonized as recklessly risky investments. Others tout options as useful tools for managing risk in a portfolio. An aspect of stock options that isn’t discussed much is the frictional costs of commissions and spreads in stock option investing. The people I have known personally who have dabbled in stock options have been burnt badly. They approached options with a gambler’s mentality and lost. This is enough to justify the advice many give to stay away from options unless you are an expert or are getting advice from an expert. On the other hand, if used correctly, stock options can reduce the overall risk in a portfolio. There is no free lunch, though. If the portfolio risk is lower, then the expected return is lower as well. An aspect of stock option investing that has always concerned me is the high friction. Frictional costs are the costs associated with trading in and out of stock or option positions. When I buy or sell stocks or ETFs, I pay a visible...

I disagree with Warren Buffett on a point about his stock option trading. There, I said it (or wrote it). It’s rare that I disagree with anything Buffett writes. In fairness, it’s not that I think he made a poor investment. It’s just that I think the real explanation of why his investment is a good one is different from his justification. Buffett’s eagerly anticipated 2008 letter to shareholders of Berkshire Hathaway arrived on Saturday. It contains his usual brilliant financial insights expressed clearly. Any number of reporters will summarize its contents, but those interested should consider reading the original letter as well. One aspect of the letter that caught my attention was the discussion of Buffet’s option trading. He believes that certain long-term put options are mispriced, but his explanation of why they are mispriced leaves out the dominant reason. Buffett has sold put contracts on the world’s major stock indices. These contracts amount to bets between B...

A while ago I discussed how to build your own market-linked GIC . A friend (who prefers to remain anonymous) mentioned that his market-linked GIC has a maximum return. It turns out that he has what Scotiabank calls its “Market Powered” GIC or MPGIC. This MPGIC is similar to other market-linked GICs in that its return is linked to a stock index. In this case, it is linked to the TSX 60 index of large Canadian companies. This GIC also returns only a fraction of the index return, called the participation rate or participation factor (PF). Three differences with the MPGIC compared to other products I’ve looked at are 1. it guarantees a minimum return, 2. it caps the maximum return, and 3. it bases market return on the average index value over the whole time period instead of just an average over the last year of the GIC. For the 3-year MPGIC, currently the guaranteed minimum return is 0.5%/year and the maximum additional market-linked return is 20%. Once again, we’ll try to...

A reader made an interesting observation about last week’s post on building your own market-linked GIC with stock options . Econstudent noted that using call options, you lose out on the stock’s dividends. So, let’s build an investment with principal protection that doesn’t lose out on the dividends. Recall that our earlier strategy was to invest most of our $100,000 in a 3-year GIC that matured to a value of $100,000, and used the left over money to buy call options on the TSX 60 stock index. This fully protected the initial principal, and gave some upside if the TSX 60 rose over the 3 years. Another approach is to actually buy the TSX 60 in the form of the exchange-traded fund XIU with most of the $100,000. Then buy long-term put options on XIU, and invest any cash left over in a GIC. The put options provide principal protection in case stocks drop, and you get to collect dividends during the three years you own XIU shares. The dividend rate on XIU is about 4.8% right now,...

A risk-averse friend was asking me about market-linked GICs as a possible investment. He believes this is a good time to own stocks, but wants protection against losing any money. Market-linked GICs seem to be a good fit, and so I decided to take a closer look. The particular GIC my friend mentioned was Royal Bank’s 3-year GIC linked to the TSX 60 index. The basic idea is that if the TSX 60 goes up after 3 years, you get a return, and if it goes down, you get your principal back with no return. However, if the TSX 60 goes up over the 3 years, you don’t get the full return. For example, if the TSX 60 goes up 50%, your $100,000 GIC won’t grow to $150,000. If it worked this way, it would be the same as owning the TSX 60 stocks with a side promise to give you back your full $100,000 if the index goes down. Banks aren’t in the habit of giving out free lunches like this. Enter the “participation factor,” or PF. The bank actually promises you a percentage of the TSX 60 return. S...

I’ve been getting a lot of requests lately to place advertising on my blog. Unfortunately, most of it is completely inconsistent with my message about how to handle money. Many are from payday loan companies. It’s sad that some people have got their finances into such bad shape that they feel the need to take loans from these companies at such exorbitant interest rates. The latest advertising request came from a web site (that I won’t name) devoted to strategies for gambling with stock options. There are some sensible uses for options, but this web site was not promoting sensible strategies. The strategies were a long-winded version of the following: “If you think a stock will go up, buy a call option.” “If you think a stock will go down, buy a put option.” “If you think a stock will have a big move, but don’t know which direction, ...” And so on. There are dozens of option strategies for ever more specialized situations. The problem is that you can’t predict the future to tell wh...

In his book Money for Nothing and Your Stocks for Free , author Derek Foster offers two strategies for boosting investment returns: selling put options and leveraging your house. Let’s examine these strategies. 1. Selling Put Options Foster suggests finding a good dividend-paying stock that you’d like to own. However, instead of just buying the stock, he wants you to sell put options on the stock. How this works is best explained with an example. I’ll use some actual (approximate) figures for Royal Bank stock (ticker: RY). Let’s say you’d like to own 200 shares of RY that are currently trading for about $46 each. You could just buy the stock for about $9200 right now, or you could sell put options on 200 shares. Royal Bank December put options at $44 have a premium of about $3.50. This means that someone is willing to pay you $3.50 for the option to sell you a share of RY for $44 any time between now and the third Friday in December. Based on 200 shares, you can collect ...

The Big Cajun Man wrote about the worst financial advice he had ever given , and he challenged other bloggers to admit to bad advice they have given. I had to think about this one for a while. The truth is that while I have opinions on just about every financial subject, I don’t advise people directly very often. For example, although I often say that trading stock options is a very bad idea for most people, it could be right for a particular person. Then again, most of the people who think it is right for them are mistaken. There was one period of time where I suggested a way of thinking about investing that didn’t work out the way I thought it would. During the high-tech boom, I worked for a company that had given almost all employees stock options. The stock rocketed skyward making these options very valuable. Employees spent a lot of time discussing when to sell and how much. I suggested to several coworkers that they imagine that the options were exercised and the stock sold...