I buy and share baskets of stocks called Coffee Cans. You can see the most up to date list of stocks and their performance here on my Scorecard.  Note: Coffee Can 5 is still under construction, and likely a riskier basket than those in the past.

Earlier I wrote about a company called NVR. One ingenious thing they did was to use options to control pieces of land as opposed to buying the land outright. This let them limit upfront capital at risk, but also let them participate in the upside of the land development. I think this is a very powerful idea.

We can similarly control large amounts of stock with relatively small amounts of capital via options. When we buy an option, what we’re essentially doing is taking out a special loan, one that requires no collateral, and no payback. 

Let me explain.

A Quick Refresher 

If you’re new to Options, see:

• Option Basics 1

• Option Basics 2

Recall that a Call is simply the right to buy 100 shares of a stock for a specific price (i.e. the Strike Price) by a certain date (option expiry date). 

Bullish on Microsoft

Let’s imagine we’re bullish about Microsoft’s future. To profit from future price appreciation, we could buy the stock today for $21,300 (100 shares @ $213/share), or we could consider buying an option instead, which would let us “control” the same number of shares. 

Let’s assume, we wanted to make this investment over the longest time frame possible. The longest dated MSFT options available expire on September 16 2022 (in ~2.2 years). Let’s use the MSFT $180 Strike Call Options for this example. 

These Calls currently have an “intrinsic value” of ~$33. Why? Because the call buyer can immediately exercise their call, buy the stock at $180, and sell it in the market for $213 (a difference of $33).

But the Calls actually cost $56.50, that’s $23.50 extra! Why? The answer lies in understanding the benefits of owning a Call.

Benefits of Owning a Call

First, the owner of the Calls doesn't have to lay out $180 for over 2 years, yet she is entitled to all of the stock's appreciation until then. This has value. 

Second, buying Calls has a defined risk. For example, if MSFT were to crash to $100, the Call owner would lose only $56.50, but the MSFT stockholder would lose $113! This also has value.

But, What’s in a Call...Really?

Our calls cost $56.50 despite having an intrinsic value of $33. So if I buy these, I am essentially paying $23.50 in upfront interest payments to borrow $213, minus the $33 of intrinsic value. 

Therefore, the cost of borrowing is $23.50 / ($213 - $33) = ~13%.

My effective annualized borrowing cost is roughly 6% since there are 26 months to expiration. 

So, the difference between me buying MSFT stock today vs this Call is that, instead of putting up $21,300, I could pay just $5650 (a ~73% reduction in capital needed), $2350 of which are financing costs, and control the same 100 shares of Microsoft stock.

Looking at it another way, the above is like buying a house with 27% down, but without all the hassle: No Agents/No Open Houses/No Appraisals/No Lenders etc...

And no frictional costs (buying an option costs only $0.65, yes 65 cents!). 

A Couple of Callouts

Timing: 

• Timing is a major risk. Recall that options are depreciating assets. They lose value over time. So before you buy such long dated options, you must ask yourself: Is ~2 years sufficiently long for your investment thesis to play out? Maybe. Maybe not. You must decide.

• Remember, if you’re wrong, you could lose 100% of your investment, so be careful. 

Dividends: 

• With options, one thing you are leaving on the table is dividends. Unlike shareholders, call holders are not entitled to dividends. But that “drawback” is reflected in the Call price. Plus I’d say reliable dividend yields are likely only in the low single digits. Considering the leverage involved with options, dividends are likely a non-consideration in the investment decision. 

Wrapping Up

The more I learn about options, the more they fascinate me. 

Options, used effectively and with sound risk management, can be an important part of an enterprising investor’s toolkit, especially for someone looking to compound at high rates of return.

One of the things on my to-do list is to look back at my stock investments and calculate how the “equivalent” option investments would have fared. 

So far, a big reason I have deployed only small sums via options is because of their short lifespans (max ~2 years). My investment time horizon tends to be longer than that. But, considering the significant price movements in the stocks on my scorecard, I wonder whether similar returns could have been had with much less capital at risk. Perhaps my perception of ~2 years being too short is incorrect or too conservative? 

Something to study. 

Note:

If you’re reading this, and have easy access to historical options data, I’d love your help with the above!

OR

If you’re a data scientist/software developer who’d be interested in helping with the above or similar analysis, I’d love to speak with you.

Thanks in Advance!