Education Newsletter

Many advanced option veterans avoid trading stock, but there are times when it makes sense to use both in certain strategies.

Covered calls are usually the first option trade that people learn, selling calls against long stock to generate income and lower the cost basis of the shares. From there, traders often move onto buying puts as protective hedges and/or to using collars, which simply combines the two strategies.

After getting this initial taste, many traders decide that they'd rather use options alone. For example, they find that selling cash-secured puts theoretically carries the same risk as a covered call but has advantages over the latter strategy.

Moreover, buying puts against long stock can be replicated by buying calls, which has a much lower margin requirement. And collars are essentially identical to long-call vertical spreads, which tie up much less capital.

But there are times when combining options with stock makes the most sense, especially for long-volatility plays. Some traders believe that it is much easier to see if volatility is too high or low than to pick the direction of the underlying stock. If traders think that volatility is too low but aren't sure about the stock's direction, they could opt for positions that are long volatility.  

Others are introduced to the long-volatility concept through the long straddle. The straddle is simply the purchase of long calls and puts at the same expiration and strike. So if XYZ shares are trading at $50, you would buy the $50 calls and $50 puts. If XYZ moves sharply in either direction, then the position can profit.

The problem with long straddles, however, is that you are paying the premium of two option contracts and have to overcome time decay in both. Many people try straddles going into earnings, which is often the worst time to be long lots of option premium because it gets pumped up going into the unknown news.

Unfortunately, it quite common for us to hear from new option traders who have lost money this way. Others might be long just calls or puts and were right on the stock's direction but still lost money because the so-called volatility premium they paid was too high.   

But you can create a similar position by buying either puts or calls and trading stock against them in what is known as delta-hedging. For instance, a trader might buy at-the-money puts and then delta-hedge them by purchasing the same number of shares.

If an option's delta is -0.50 and 10 contracts are bought, then the overall delta is 500. So 500 shares would need to be purchased to create a long-volatility, delta-hedged position. In this sense, using the options against stock instead of a long straddle can be a better way to "buy" volatility. (See SPY example in graphic below)



Conversely, many traders do the opposite to create short-volatility positions. It can be argued that the short straddle makes more sense because of the double time decay mentioned above, but the stock-and-option position is easier to manage and continuously hedge.

Again, most option traders don't use stock in strategies that can be easily replicated by options alone, but delta-hedging volatility positions is the exception.

(Graphic courtesy of tradeMONSTER)

We frequently hear that investors want to own "dividend-paying" large caps. This is mostly true, but something bigger has been happening that I'd like to explore today.

First, it's important to realize how new this trend is. The S&P 500, an index of large-cap stocks, is up almost 7 percent in the last year (through yesterday's close). The small-cap Russell 2000, meanwhile, has lost 1.6 percent of its value in the same period. This marks a major change from the preceding decade, when small caps consistently outperformed in positive markets.

Second, the story is less about market cap and more about business and sector. Occidental Petroleum, for example, is 9 times bigger than Kimco Realty. But it's down 11 percent in the last year, while KIM is up more than 2 percent.

Most of the strength has actually come from consumer staples, health care, pipelines, utilities, and real-estate investment trusts. Other S&P 500 companies have lagged, especially in energy, materials, and the financials.

Two big themes are emerging. The first is that people seem to be shying away from stocks that are economically sensitive or "pro-cyclical." This is not a surprise because the global economy is looking increasingly weak.

The second theme is that investors want companies with real assets that will keep their value long into the future. Utilities and REITs fit this bill admirably because they own transmission lines, rights-of-way, and buildings. Pharmaceuticals also work well because their patents ensure similar long-term cash flows.

American Tower and SBA Communications embody this theme. As owners of cell-phone towers, they were relatively obscure tech companies for years but have caught fire recently by restructuring themselves into REITs. AMT's dividend is less than 2 percent and SBAC doesn't even pay a dividend.

In contrast, a financial like Annaly Capital Management, which has a comparable market cap and a much higher dividend, has gone nowhere. That demonstrates that the story isn't about the yield per se, but the kind of business.

The trend also emerges in the energy sector, where refiners have outperformed oil producers. After all, their physical plants will continue to generate cash indefinitely. In some ways they're like cell towers because, as much as people rely on gasoline, no one wants to let new ones be built.

Also look at Latin American brewers Ambev and Cervecerias Unidas. The region has performed terribly over the last year, but these stocks have been trending higher because they have deep roots--not just in the economy but in the society. Again, the bias is toward non-cyclical sectors such as consumer products, utilities, and pharmaceuticals.

The new sentiment only began in earnest last summer, as China slowed and fiscal angst engulfed Europe. Over preceding decades, investors had always focused on growth--whether it was in technology, mortgages, emerging markets or commodities. This remained true even after the mortgage bubble burst, when money rushed back into energy and materials.

But now a very different future stands before us, marked by heavy debt, low birthrates, and increasingly bad leadership in government and central banks. It's hard to see anything changing soon, so this new trend toward safety could last a long time.