It almost seemed like a no-brainer. On a Tuesday in mid-January, Netflix Inc. was set to release its latest financial results after the close of regular trading. Despite new players trying to duplicate the company's success in video streaming subscription, Netflix had been expanding in new markets and continually adding new content. Surely their numbers would be strong, and the stock would pop.
As it turned out, that's exactly what happened. Netflix's profit and subscriber growth topped analyst expectations – and its stock price immediately jumped by 13 per cent. It was a nice gain for Netflix shareholders – but for those who had made a bolder bet on the company, the return was much greater. The value of one Netflix security tripled in price … an instant 200-per-cent return for anyone who played it right. However, if the Netflix results had been weaker than expected, the value of those securities would have been almost nothing.
That's the way it goes in the world of options trading. The potential returns are big and quick – but the risks are also very high.
"Options are kind of like buying a lottery ticket," says fund manager Derek Webb. "The probability that you're going to make money is low, but if you do make money, you will make a lot of it."
Mr. Webb is the director and chief executive officer of Sausalito, Calif.-based Webb Asset Management Inc. He has more than 30 years' experience as a manager of investment funds both in Canada and the United States. He says nobody needs to invest in options – but they can be an effective tool for those who understand them and are looking to achieve a specific strategy.
The definition of an option is a contract which gives the buyer the right to buy or sell an underlying asset at a specific price on or before a specific date. An option that gives the owner the right to buy something at a specific price is referred to as a "call." An option that gives the owner the right to sell something at a certain price is named a "put."
The call option gains value as the price of the underlying security passes the "strike price," or contracted price, of the option. And on the flip side, the put option becomes more valuable as the underlying asset drops below the strike price. In the Netflix example, it was the call options that soared in value – specifically, the right to buy Netflix shares at $410 apiece. These options suddenly became quite attractive as Netflix shares jumped from $349 each to $417.
A key factor to remember with all types of options is their time horizon. They expire on a set date – so if the scenario you're betting on doesn't materialize in that specific time period, they will never gain significant value before expiring and becoming worthless. Mr. Webb notes this makes options most useful when you are speculating on the outcome of a very specific event – such as a company's earnings report.
While the adrenaline-filled way to use options is for this kind of speculative trading, there is also a more conservative options strategy. When an investor owns a stock (or other security) and sells a call option on that asset, it is referred to as a "covered call." An increasing number of investors use this approach as a way to generate additional income from their holdings. And unlike trading in "naked" calls (trading in options without owning the underlying security), there is much less risk, since the investor owns the underlying security – they are just being paid by someone else to allow that person to speculate on the stock's movement. Naked calls can be dangerous, in that contract holders can lose far greater amounts of money than the price difference between the contract and the share price, since they are on the hook for the underlying price of the security, which can swing greatly.
John Hood is a big fan of the covered call strategy. Mr. Hood has more than 35 years' experience in the securities industry. He is now an independent portfolio manager based in Pickering, Ont. He says covered calls are an effective way to add to what he calls the "meagre returns" of fixed income investing. "If I manage the timing properly, I can pick up 5 to 6 per cent over a six-month period," he says.
While individual investors may be able to use the covered call strategy based on their other holdings, they can also take advantage through specific mutual funds and exchange-traded funds. Mr. Hood says Bank of Montreal's group of covered call ETFs can be an effective choice.
Mr. Webb is also a big advocate of the covered call strategy for individual investors. But whether it is covered calls or the more speculative approach, he raises another factor to bear in mind: cost. "Options trading can be very expensive – the transaction fees for retail investors can add up and really cut into returns." On the positive side, most options are RRSP eligible, and available through Canadian brokerages.
The bottom line seems to be that options investing can play a role in retail investor portfolios – but they are not for everyone. "They're really only for sophisticated investors," Mr. Webb says. "You need to have a specific strategy and time frame, and a high probability of a certain event taking place." After all, even companies such as Netflix can't be counted on to wow the market every quarter.