If you have read much of my blog, you know that my stock market investing strategy is simple. And it doesn’t include stock options, derivatives trading, or the futures market.
Put simply, my stock investing strategy is as follow:
- Save and invest in broadly diversified, low cost index funds for the long term and
- Rebalancing to my asset allocation yearly.
Truly, if you want to invest in a manner that will beat 80% of active investors using a laughably low maintenance strategy that you can do yourself, that is all you need to know about the stock market.
That’s the beauty. Investing successfully in the stock market is quite simple. Despite seeming very complicated and risky.
But there is a dark side…
We commonly hear people talk about the more complicated aspects of investing. Things like stock options, derivatives, and futures. We wonder if we are missing something.
Maybe there is a better way than index fund investing…
It’s tempting. Especially when we don’t really understand these strategies and how they work (because we lack financial education). From an uninformed position, we can neither confirm or deny their advantages now understand their risks. That makes us vulnerable.
So I do believe it’s important to understand stock options, stock derivatives, and futures. And that’s the goal of this post. At the end, we will examine if these advanced investing strategies are right for you or most physicians/high income earners.
First, a quick catch up on why index fund investing should be the core of everyone’s portfolio
By investing in broad, low cost index funds, we are placing our investment bet on the overall US (or world) economy to continue prospering. We are investing for the long term so we do not care about short term fluctuations. And the long term trend for the overall stock market over any extended period has always been up.
But, by investing in this manner, we commit ourselves to earning the market average. No better, no worse. And no one wants to be average, right?
Well, it turns out that average is pretty great in the stock market. In fact, 80% of managers who invest actively to try and do better than average do worse than the market average! Plus, active strategies incur more fees and taxes. So any benefit usually gets wiped out anyway, even if you are the lucky 20% that beats the market.
Even more, as high income earners, we need to win consistently and limit losses to achieve financial freedom. We don’t need to take unnecessary risk to grow wealth. As long as we save 20% of our income and invest to not lose, we actually win.
And now, back to the dark side
For better or worse, an index fund strategy is boring. And many investors have a gambler’s itch. Or an ego that believe they can truly beat the market.
And that is where stock options, derivatives, and futures come into play. They are generally seen as pure speculation. And in many ways they are due to the way investors use them today.
But it wasn’t always that way.
An introduction to derivatives, futures, and stock options
First, let’s get a few definitions out of the way.
I’ve mentioned before, but there are people in finance who are complexifiers and people who are simplifiers. Just like in medicine. Complexifiers usually either don’t understand what they are trying to explain or do understand it and try to make it complicated so you don’t understand it. And then pay them for their services.
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So let’s simplify all of this fancy stock derivatives, futures, and options jargon
Derivatives are simply financial products that are traded and carry value derived from the underlying asset. For instance, a stock future, which I will define below, is a derivative because it’s based on the fair market price of the stock . So this is just a broad category into which futures and stock options fall.
A futures contract is an agreement between two parties to exchange a set of goods at a set price in the future. A butcher agrees to buy 10 cattle at $500/cow in 3 months. That is a futures contract. You are obligated to buy (sell) the agreed goods at the agreed price on the agreed date. You can also trade stock futures by agreeing to buy a set number of shares at an agreed upon share price in the future.
Options are contracts that give you the option to buy or sell an asset at a set price (the “strike price”) at a future date (the expiration date). You don’t have to buy it. You can just let the contract expire if you don’t want to buy or sell it by the specified date. But you pay a premium in order to buy the options contract.
And there is more than one type of option. A call option gives you the option to buy an asset at a set price at a future date. A put option gives you the option to sell an asset at a set price at a future date. These are the main different types of stock options.
What is the point of all this?!
That was the first question that came to my mind as I began learning about these instruments. They seem like contrived attempts at finding new ways to
invest speculate purely in the hopes of making money. I didn’t perceive a real economic or practical benefit.
But there actually can be. And that’s how futures and options started historically.
For instance, futures contracts for commodities like beef or grain allow farmers or growers to ensure they will receive a fixed price for their goods. Let’s say you are the butcher in the example above. A futures contract makes sure that you will have beef at a fixed price regardless of what happens to the beef supply or market. Those are legitimate economic benefits.
In my mind, things started to go sideways when equities started to be traded with futures and options. And this is when options trading really took off, especially in the United States! Are there potential, real economic benefits? Yeah I guess. You can hedge investments against each other to limit potential losses. But again, if you are doing this, you likely are investing in too risky a manner. (Cue my broken record telling you to invest in low cost broadly diversified index funds.)
Still others argue that stock options and derivatives help keep the market efficient by bringing stocks back to their intrinsic value. This is an important point. But that doesn’t necessarily mean that you need to be the one doing this. In general. institutional investors with a huge investment portfolio will be the only ones all to make such impacts as “market makers”.
How do stock futures and options work?
Basically, how do investors try to use these financial instruments to make money? Let’s explore with a few examples. In these examples, assume that we are always talking about stock futures and options, not commodities like grain or beef. Also, I am using made up round numbers for the sake of simplifying the math involved.
When trading stock futures and options, no actual physical goods are exchanged. Shares are even actually exchanged. The buyer or seller just have to pay the other difference between the agreed upon price in the futures or options contract and the current fair market value of the stock at the time the contract is exercised.
Confused? Let’s break this down.
Starting with futures…
Let’s say that I believe that the overall stock market is going to go up in the future. Today, the S&P 500 is trading at $1,000. I buy a 3-month futures contract for 100 shares of the S&P 500 index fund at $1,000. This means that in 3 months, I have to “buy” 100 shares of an S&P 500 index fund for $1,000/share.
If in 3 months, the S&P index is valued at $1,200, that means I guessed correctly. That’s good news! I would simultaneously buy my 100 shares at the predetermined price of $1,000/share ($100,000 total purchase) and sell those 100 shares for the market price of $1,200/share ($120,000 total sell). This means that I made $20,000. In reality, the seller of the futures contract just gives me (the buyer of the futures contract) $20,000.
Now, let’s say that, in 3 months, the S&P index went down to a lower price of $800. This means I guessed wrong. Now, I have to buy the same 100 shares for $1,000 each even though that is well above the market value. I spend the same total $100,000. Simultaneously, I can only sell them each for $800 or $80,000 total in selling. Thus, I lose $20,000 and the seller of the contract makes $20,000.
Now let’s look at the following example with stock options…
I’ll set the scene. Again, you believe that the overall stock market is going up. Today, the S&P 500 index is valued at $1,000 per share. So, you buy a 3-month call option contract at $5/share for 100 shares of an S&P 500 index fund for $1,000 per share. Essentially, you just paid $500 ($5/share for 100 shares) for the right to buy 100 shares of the S&P 500 index fund at that price anytime within the next 3 months.
If at any time within the next 3 months, the S&P index is valued at $1,200, I’m right again! I would exercise the call option and simultaneously buy my 100 shares at the agreed upon $1,000/share ($100,000 total purchase) and sell those same 100 shares for the market price of $1,200/share ($120,000 total sell). This means that I made $20,000.
If at no time within the next 3 months, the S&P 500 index is values higher than $1,000, I would just let the call option contract expire. I don’t have to buy anything. And all I lose is the $500 that I spent to purchase the contract.
Keep in mind here that the opposite of this example of a call option is a put option contract
In that example, you think the S&P 500 index is going down. So you, the option holder, agree to sell for a fixed price in the future, hoping that the value falls below that agreed upon price during this period of time. If it does, you win. If it doesn’t you let the put option contract expire and are out the premium paid for the contract.
You can run the same examples for different stock indices, Treasury bills, bonds, and many types of common stock. Regardless of the asset of interest, all you are doing is guessing on the future value of that asset.
Stock futures and options come with potential massive reward…with a cost
And that cost is massive risk. Whether investment advice from a financial advisor or other “expert”, many investors and even institutions have lost their shirts in stock derivatives. This is largely what happened in the 2007-2008 crash with derivative trading in mortgage backed securities.
Let’s look again at the examples above.
In our call option contract simple example, we essentially bet that the S&P 500 index would rise above the “strike price” of $1,000. If this happened at any point within the 3 month contract period, we would exercise the call option and make money. And all we had to pay to have access to this massive return was the premium to purchase the contract.
This is where the massive potential reward with stock options comes into play. The derivatives market gives investors access to huge leverage to be used buying stocks.
In converse, if the S&P index did not cross the specified price of $1,000 within the 3 months of the contract, you let it expire and are out the premium paid. In this case, the premium was $500. So, not too bad, right?
Of course this is a contrived example. In reality, premiums to buy call and put options can be quite expensive. Especially for more volatile stocks and for longer contract periods. These factors increase the value of an option. So incorrect bets and lapsed contracts can add up quick!
Further, what if the price of the option you paid was not just $500. Imagine it was $1 billion. Scared yet?
Things get even more daunting with futures contract. In this case, you don’t have an option not to buy when the waiting period is up. You have to buy.
If we guess right, we win. But if we guess wrong, we lose the same amount. Meaning we have to have that money as collateral and back up.
In other words, you had better be pretty darn good at guessing the market. Unfortunately, no one has shown this propensity with any consistency. Like Buffet says, “derivatives are weapons of mass destruction.”
Can stock derivatives hold a place in your portfolio?
Can they? Sure.
But same as anything else, I would limit them to play money. Nothing more than 5% of your portfolio is you have that gambler’s itch that just needs to be scratched.
Like I mentioned earlier, these strategies can be used to hedge your portfolio to limit losses. Let’s say that you hold a large percentage of your portfolio in a single stock that you worry will drop in price. Selling that stock would trigger a massive capital gains tax event.
So instead, you would become an option writer (seller) and sell (write) call options on the stock. If the stock price does fall, the buyers would let the contract expire and you would pocket the option price (premium). Of course you would have to pay ordinary income tax on these premiums, but we are ignoring that for simplicity sake. In the meantime, if the stock unit price rises, you would lose some money, but still benefit from the appreciation of your shares of the company.
In this case though, I again would argue that your portfolio is way too risky with a large percentage in just one individual stock. If you find yourself needing options contracts to hedge your portfolio, you’ve constructed the wrong portfolio.
So maybe the real question is…
Should stock derivatives hold a place in your portfolio?
It’s just not necessary.
You are a high income earner. You don’t need to leverage massive risk for potential massive reward. In fact, you don’t even need to score a massive reward with your investing.
You just need to consistently save and invest for consistent wins. Go for singles not home runs. And you are guaranteed to win. Investing is like amateur tennis. Just make less mistakes. And investing in stock futures and options is just asking to make a mistake!
Keep.It.Simple.Stupid. At least this is what I tell myself!
Then I remind myself of these basic principles of successful investors, look at my written financial plan, and remember how I’m winning my way to financial freedom each day!
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What do you think? Have you invested in stock options or futures? Do you think they should be a part of your portfolio? Let me know in the comments below!