Done With Robinhood Trading 101?
How about the 202 class on options?
For many investors, options are a scary non-starter: their unlimited downside means portfolios can potentially go to zero overnight due to a single bad bet. In July, Robinhood (NASDAQ:HOOD) settled a lawsuit over the suicide of a 20-year-old trader who believed he owned $720,000 in losses last summer. He probably won’t be the last tragic tale.
But much like using a sharp kitchen knife (or fishing with dynamite), options are powerful tools when put in the right hands. It’s one of the few asset classes that can turn $50 into thousands of dollars without many of the traditional downside risks.
I’ve long recommended readers watch InvestorPlace’s Options MasterClass — a phenomenal introduction to using options as financial weapons to your advantage.
And now it’s your turn to get started. So today, we’ll take a look at some low-risk ways to get started in the wild world of options.
Options Trading on the Upswing
When Reddit traders collectively decided to send Gamestop (NYSE:GME) to the moon last January, they stumbled upon a Wall Street oddity: gamma squeezes. Writers and bloggers have been struggling to explain the phenomenon since.
In short, though gamma squeezes are less common than short squeezes, they’re far more potent because of the leverage built into options. Under the right circumstances, an investor putting $100 into options can trigger $10,000 or more in buying by market makers.
It’s little surprise that options trading on mobile app Robinhood has soared ever since.
Leverage (i.e., Investing With Other People’s Money)
At first glance, options seem harmless enough. They’re contracts that allow you to buy (or sell) an asset at a pre-determined price.
But hidden in that language is a wild world of virtually unlimited leverage.
Consider a stock like Microsoft (NASDAQ:MSFT). A regular investor who believes the stock will rise 25% to $380 by year-end could buy shares today for a 25% return. An aggressive one could buy the company on margin at a 2-1 leverage, which could magnify gains to 50%.
Both strategies, however, can also fall 25-50% if MSFT suddenly drops by a quarter.
To save that heartache, bullish investors can buy a call option with a $360 strike price at $2.50. If Microsoft shares end up at $380, you pocket the $20 difference (i.e., $380 minus $360). With an entry price of $2.50, that’s a 700% return per share. And if Microsoft ends up down, the most you lose is that $2.50 premium per call option.
So, what’s the catch?
Like any good thing, too much can spell disaster.
Options Trading for Experts
There are two ways options usually blow up portfolios:
- Overexposure. Options that expire out-of-the-money are worth zero. I recommend a 10% maximum position in options at any given time.
- Selling options. Investors who take the other end of the trade (i.e., selling options instead of buying) face unlimited downside risk.
For more information on trading options, watch this video from InvestorPlace’s Options Masterclass.
Two Low-Risk Options Trades for Getting Started
Building confidence in options trading means getting some good experience and easy wins. Here are three ideas to get you started.
TPG Pace Tech Opportunities (PACE) $10 Calls, March 2022
Investors woke up on Friday to startling news: Bill Ackman’s Pershing Square Tontine Holdings (NYSE:PSTH) was planning to shut down.
Ordinarily, you might expect PSTH to fall. “No deal” sounds like the death knell for any SPAC.
Instead, the SPAC traded sideways. What gives?
Well, every SPAC share is backed by cold, hard cash. So without a deal, PSTH would return $20 per share to every shareholder.
Intelligent investors will immediately sense an opportunity for low-risk returns.
Consider TPG Pace Tech Opportunities (NYSE:PACE), a SPAC run by one of the most experienced dealmaking firms in Wall Street history. The stock currently trades at a slight discount to cash, which means its options are cheap too. Implied volatility (IV) sits at 40%, pricing at-the-money options at around $1.20.
This bet could be worth a gamble. SPACs have tended to rise after announcing a deal (particularly tech-based mergers), and PACE jumping to $15 would represent a 320% return for investors. A rise to $22 would be a 10x return. And at worst, you’ll only lose the $1.20 premium you paid upfront.
Desktop Metals (DM) $7.50 Calls, December 2022
Experienced investors will know that price is only one factor for options. Volatility often matters just as much.
That’s the reason options in stable companies like 3M (NYSE:MMM) are downright cheap compared to meme stocks like AMC Entertainment (NYSE:AMC). And it’s also why investors should consider calls in Desktop Metals.
I’ve already highlighted Desktop Metals (NYSE:DM) as my favorite 3D printing firm. The company’s strong products give it an edge over its competitors.
What’s less clear is how its long-dated call options have gotten so inexpensive. Though DM has fallen 25% below its SPAC listing price, near-the-money options for late-2022 are still priced with an implied volatility of 75%. For reference, options in similarly-priced Clover Health (NASDAQ:CLOV) are trading at 115% IV.
Both growth and value-minded investors should sense an opportunity. Desktop Metals’ recently-announced acquisition of rival ExOne (NASDAQ:XONE) will likely raise DM’s volatility as the merger date approaches. Bouts of M&A tend to disrupt profit margins, especially when fewer than four major players are involved.
That makes DM’s calls extremely attractive relative to other mergers. Investors buying $7.50 calls for December 2022 pay a premium of just $2.60, and rising volatility could keep investors above water. Should DM return to its 52-week high of $35, investors will reap a 10x return.
Chinese Stocks Continue to Disappoint
Regular readers will know that I’m not a fan of most Chinese ADR Moonshots. Having started my career in Asian equities, I was taught to read Chinese annual reports with skepticism.
Though reporting standards have improved markedly since then, one thing has remained constant: the presence of the Chinese Communist Party (CCP).
“Though shares of the Chinese private tutoring companies fell -60% last week, these firms are anything but a bargain. The Chinese Communist Party (CCP) has made life impossible for entire industries before — think of Beijing’s coal-burning plants in 2008. And there’s no reason they couldn’t do it again.”
That was the right call: since then, these stocks have continued to circle the drain. Investors can now buy Gaotu for $2.50, down from $149 earlier this year.
Short-sellers, however, should now close out their positions. Last Wednesday, Gaotu’s well-manicured press release suggested a potential compromise with the Chinese government.
“Prices for Academic AST will need to follow the guidelines from the government to prevent any excessive charging or excessive profit-seeking activity,” they reported. That’s very different from what Beijing initially mandated.
In other words, these for-profit firms might survive as lower-profit companies (as opposed to non-profit).
I wouldn’t bet against these companies under the circumstances. Gaotu now has 30% of its shares sold short; any change in CCP language could send the stock on a wild short squeeze ride. Short sellers, be warned.
What Happens When Governments Disallow Profit-Making?
|$85||The peak Fannie Mae stock hit in the 2000s before the 2008 housing crisis.|
|0%||Amount of net profit public Fannie Mae shareholders receive today. A 2012 agreement with the federal government forces FNMA to turn over virtually all profits to the U.S. government.|
|$11.8 billion||Net profit FNMA earned last year, $3.7 billion more than at its stock peak in 2002|
|$1||The current price of FNMA stock.|
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The Power and Pitfalls of Asymmetric Bets
We’ve seen this story before. Stock markets hit new highs, but investors are scared.
Often, people blame high valuations. Experienced investors will recall the “Nifty Fifty” bubble of the 1970s when “one-decision” stocks like McDonald’s (NYSE:MCD) and Disney (NYSE:DIS) reached valuations of 86x and 82x P/E, respectively. Younger stockholders might recall the 1990s tech bubble or the crypto-mania of 2018.
But at its core, people are scared because they don’t want to lose money. And when prices are especially high, there’s so much more you can lose.
That’s where asymmetric bets come in. When you make a one-sided bet, the rewards will far outweigh the small costs of playing. And just like fishing with dynamite, make sure you’ve studied up on how to pull the charge.
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On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.