How Stock Options Can Help Your Shrinking Nest Egg
Stock options are on the rise among investors with the stock market rocking and rolling with volatility. A call option gives you the right to buy a stock and a put option gives you the right to sell a stock. To see how to make use of these mechanisms, we turn to an expert on the subject, Steve Sears, president and COO at Options Solutions in New York
Larry Light: Options have surged in popularity in recent years. Why?
Steve Sears: Since the global financial crisis of 2008 and 2009, investors have learned that volatility is either something that happens to them or something that they can try to do something about. Puts and calls offer investors the ability to do something more than just get bounced around by Mr. Market. This is one key reason that so many investors feel that options are no longer optional in their portfolios.
There is another key reason, too, and it is not well understood. Many investors have learned—through difficult experience—that what they were told to do by Wall Street has not turned out as expected.
Light: Like what?
Sears: Huge swaths of people have now amassed significant first-hand experience investing and they are comparing what has happened with what they were told would happen. Remember, Main Street’s embrace of Wall Street is a relatively recent phenomenon that began in 1975 when fixed commissions ended and it was no longer prohibitively expensive for most people to buy stocks. The introduction of electronic trading and brokerage firms, which has really occurred over the past 20 years, has helped to bring Main Street into deeper into Wall Street’s embrace. Yet, John and Jane Investor’s account balances often lag what they were told to expect.
This is one reason why, as we have discussed before, that so many people are ill prepared for retirement, and thus forced to own more equities than they should at an age when they should be reducing risk. Now, as the Federal Reserve raises rates, and stock prices are convulsing lower, many people in and around retirement are extremely nervous because their nest eggs are shrinking.
Light: Most people think that options are mostly used for aggressive speculation rather than for the more noble ideals you espouse. What’s the disconnect?
Sears: The simple fact of that matter is that most people, and many reporters, understand aggressive speculation much more than they do how to responsibly invest. There is a financial literacy crisis in America that is often ignored, and even less addressed, because it is difficult to cure and hard to discuss. Besides, meme-stock mania is a catchier storyline than a piece on the importance of dividends to historic stock returns, or ways to reduce risk.
Also, we learned during the COVID-19 pandemic that America is a nation of gamblers and speculators. People want to get rich quick. They always have and they always will. One interesting sidenote to the meme-stock phenomenon is that younger investors, dare I say millennials, recognize that options can be surrogates for stocks. Sophisticated investors have long known that, but it is unusual to confront it in the general market.
Light: Fair point. What do investors need to know and do if they want to responsibly use options.
Sears: Everything starts with stocks, and acting and thinking like a disciplined investor. Understand a few key facts. Dividends account for about 45% of historic stock returns and inflation adds another few percent. So roughly half the game of successful investing is harnessing those facts and picking quality stocks or funds and holding onto those investments. Don’t let short-term moves in the market scare you into, or out of, investments. Be a long-term investor—yet with a potential twist.
Options can help investors incorporate more discipline into their decision making. Investors can use options to buy low, or to sell high, and to even reduce risk. In many instances, the money received from selling options can rival, if not exceed, common stock dividends. None of this stuff is sexy, but it can be effective. Think of this as the equivalent of eating your vegetables and exercising.
Light: It sounds to me like you essentially talking about using options to create an investment discipline and to compound investment returns.
Sears: Exactly. I’m fascinated by the disconnects that exist between Wall Street and Main Street and how coverage of investing—via media and sell-side research—often obfuscates what are essentially a few simple things that anyone can do to be more successful. If you read Warren Buffett’s investment letters, you will see that he always mentions, usually on the first page, compounding returns.
Options can be used to help investors do just that. It’s more complicated than just letting dividends get reinvested, but not much. If you understand your stocks, and your investment goals, you can without much complication potentially generate significant income by selling calls on stocks that you own, or selling puts on stocks you want to buy. Many retirees even use those strategies to generate income in retirement with the goal of just letting their stock continue to compound.
Light: In other words, rather than just buying stocks and hoping that the price will rise over time, you are using options to create a compounding engine and another source of return.
Sears: That’s right. The compounding in your portfolios occurs from the potential gains in stocks, the payment of quarterly dividends, and the collection of options premiums. Not all stocks will advance, nor do all stocks pay dividends.
When a call is sold on a stock that investors own, the money received for the call can be thought of as a “conditional dividend.” What’s the condition of the dividend? An investor must be willing to sell the stock at the higher call strike price, or be prepared to adjust the call to avoid assignment if they do not want to sell the stock.
Should the stock price remain below the strike price, however, investors can re-invest the income received from dividends and options sales into more shares of stock, which may ultimately allow the sale of even more options. The process incorporates a discipline that seeks to secure profits, while also taking advantage of potential weaknesses in stocks—and many people are learning that stocks don’t always advance—to buy more equities.
Light: Sounds too good to be true. What’s the risk?
Sears: This way of investing is not for everyone. It requires more attention, and there is generally a learning curve. There are risks, but those risks are defined. When you sell a put or call, you know the price at which you may have to buy stocks or may have to sell stocks. You can even manage that risk, but tradecraft is a topic for another conversation.
What I hope investors will remember from our talk is that they can actively manage passive investments, they can define the risks associated with owning stocks, and they can use conservative options strategies to generate income.