On April 26, 1973, the Chicago Board Options Exchange (CBOE) opened for business. Prior to that date, there was no central clearing point for the trading of options, and individual option-market makers would quote various prices for option contracts based on trader assessments of the risks associated with individual stocks. I actually had the chance to sit with one of those market makers and was overwhelmed by his ability to pick up the phone and quote various option contract prices just by looking at his chart book and the price of stocks. By 1984, option contracts traded on the CBOE exceeded 100 million. In a short ten-year time frame, options had become a major security that facilitated the implementation of various stock market investment strategies that appealed to both individual and institutional investors.
One basic “conservative” use of options is the writing of covered-call options. Simply stated, this type of option contract is an agreement to sell a stock to a potential buyer at a stipulated price within a limited time period. For this “option” the seller receives a specific amount of income. These option contracts trade in the market and their prices change as the prices of underlying stocks change. By way of the option contract, investors who own stocks that pay little or no dividends but still desire income, can hold their stocks and continue to collect income from subsequent call options. If the stock gets “called” (or the option is exercised by the option holder), the option seller will have received a price above the current market price.
Since the sales price can be set above, at, or below the current price of the stock, the option can be lower or higher, giving options sellers (or writers as they are often called) the opportunity to set their selling price (or the strike price) at a level where they might never sell the stock (high price) or where the sale will be virtually guaranteed (low price). Investors wanting to generate a moderate yielding portfolio can sit back and write options on their stocks and collect the income.
At least, that’s what the option marketers would tell prospects. They often gloated over the fact that only 25 percent of options were ever exercised, so that the chances of your stock being taken from you (called) was one chance in four. The odds of your stock being called was also reflected in the falling price of options as expiration dates drew near and exercise prices were well above the prices of the stocks.
Well, that option-selling strategy made sense to me, but since I was a growth-stock mutual fund manager, I didn’t have to worry about producing income in a growth fund. Or so I thought. Periodically, I would be called into the chairman of the board’s office for a little coaching on my portfolio strategy. On one particular day, the chairman decided that the growth fund I managed should produce some income. While I am of the opinion that a growth-stock fund is designed to produce growth, not income, I still valued my job — so I set about conjuring up a new strategy to produce income in the growth fund.
My options experience now came into play. I set about a plan to sell options on many of the stocks in the growth fund that I managed. However, to minimize the chances of losing any of these stocks to the options buyers, I sold options that had two important characteristics: They were expiring in one or two weeks and the stocks were selling well below the exercise price.
The first step in implementing this plan was to run a trial, or test. We identified various options that fit our criteria and then we bought them on paper and watched what happened. Our experience was satisfactory. We didn’t lose any stocks to options buyers and we generated enough income to satisfy the chairman of the board.
Our successful trial was converted into an actual program in November and December of 1985. We watched the income flows into the fund and we were convinced that we had hit upon a sure-win strategy for producing income. Well, that’s what we thought until growth stocks experienced a surge in the first month of 1986.
A sharp rally in our stocks came unexpectedly (what else is new), and we sat back and watched our best stocks get “called” away from us. What was even more painful was that the price of these stocks continued to rally to a point where all of the previous months’ option income was erased and we found ourselves underperforming the competition. Remember the ratio of only one-in-four options getting called? Well, what they don’t tell you is the damage those “ones” can do.
Needless to say, the option/income experiment was retired. I remember having some trouble with the chairman over relative performance. Oh, well. We will probably never know what that income strategy cost the growth-fund investors. The stocks that “got away” continued to do well. If they had remained in the portfolio …
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and principal of Victoria Capital Management, Inc.