In 2022, we crossed the financial Rubicon. The Federal Reserve ended easy-money policies and made the stock market a much rougher place. Investors know they must act with ingenuity to regain that lost equity paradise.
The heightened volatility should benefit options investors, but the takeaway after another year writing this column is that few investors really understand puts and calls.
America loves gambling, so options are generally portrayed, and understood, through that prism. The misunderstanding provides a constant stream of mistakes that benefit sophisticated investors. So it seems useful to reflect on lessons that were reinforced in 2022, on the cusp of what will likely be another difficult year.
Stocks first. Derivatives second. Buy quality stocks and curate positions with puts and calls to enhance returns and reduce risk. We have repeatedly highlighted this approach and remain stunned that more investors don’t actively manage their passive investments with options to potentially enhance returns.
Keep calm. Trade on. The constructive use of options requires strategic action and that goes against the fundamental nature of most investors who are often lazy, apathetic, or reactionary. Learn to use the market mob to your advantage.
When the mob overreacts, as it always does, take advantage of elevated fear or greed. Use short-term volatility, which is often expressed in puts and calls that expire in a month or so, to enhance stock positions.
Avoid esoterica. Think of options as tools to enhance compound returns. Think of options premiums as conditional dividends that can rival or exceed common stock dividends. Leave options complexities to professionals, who have massive computing power. If you are going to buy or sell stocks, get paid to do so. Sell cash-secured puts to buy stocks at lower prices. Sell calls on stocks you want to sell. It’s simple. It’s effective. It’s repeatable.
The dollar has an infinite life span.You don’t need massive profits to succeed. At a 70% gain on a put or call, think about reviewing positions for profit-taking. Be unemotional about losses. Strive to be disciplined, rather than greedy or panicky.
Options are path dependent.Stay on the path. The profitability of puts and calls depends on the underlying stock’s trajectory. If the stock is above or below a strike price, so goes the trade. Some feel this limits profits, but that’s wrong. Reset the position and trade again. Strive to participate in a percentage of gains over an expiration cycle and you should be fine over time.
Let the options market pay you to be a long-term investor. Sell cash-secured puts to buy stocks at below market prices. Sell calls to sell stocks at higher prices. When stocks stall, overwrite with calls and get paid to wait for the recovery. Have a system.
Quality isn’t always enough, especially in a tough market. We championed KKR (ticker: KKR) as a well-run company with smart management when the stock was around $73, and $59, and recently, at $47. Time may ultimately right the wrong, but losses are losses.
Listen to the market. It speaks loudly. Don’t ignore it, as in the case of KKR. Sometimes it makes sense to sell puts, other times to sell calls. The Fed’s support made selling puts and buying calls a great strategy for many years. The humble covered call—selling calls on long stocks—might be ready for a comeback in a tougher equity environment that seems poised to depress stocks.
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