Morningstar Advisor - Winter 2008 - 24

Gray Matters manage the risk and returns of a portfolio of individual stocks and mutual funds. But there’s added risk: The more our portfolio deviates from the holdings of our hedging index, the greater risk we have of a single stock deviating significantly from the market and reducing the effectiveness of our options as a hedge. Options on individual stocks can be used to address that risk by bounding each stock outcome independently, which brings us to the discussion of fundamental investing and equity options. A fundamental investor buys assets when they’re cheap relative to an estimate of intrinsic value and sells when they’re expensive relative to what they’re worth. The most commonly mentioned option strategy is the covered call, or selling the upside on a stock. To a fundamental investor, that upside must be overvalued by the market; otherwise, why sell? The market must be paying too much for that upside, so either the stock must be overvalued or the option on the stock (measured by implied volatility) must be overvalued, or both. (To further explore this concept, read “The Morningstar Approach to Options” and “The Morningstar Option Strategy Map”; links are below.) Extrapolating this methodology further, there is rich set of opportunities for use of options by fundamental long-term investors. For example, if fundamental research says that a stock is fairly valued at $100 and it is trading at $50, I can choose to buy the stock at $50. However, I could also choose to keep my $50 cash in my account and sell insurance on the downside of the stock for cash today, let’s say $5 for the next year. If the stock price rises over the next year, my $5 translates to a 10% return. Add to that the 5% yield on my cash in my account, and I earn a 15% return. If the shares fall and the investor has to buy the shares at the end of the year for $50, the shares are bought for $50 minus the $5 earned for the option minus another $2.50 in interest, or $42.50. If no other news has come out to change our estimate of the long-term value of this stock, we just paid $42.50 for a stock we would have bought at $50. Then, we hold the shares as long-term investors. Let’s say the shares rise to our fair value of $100. We can then sell the upside above $100 for an additional cash payment, say $10 (write the covered call we discussed earlier). Under this scenario, if the shares further increase in price, we sold the shares for what they were worth anyway, plus a premium, and if the shares fall in price, we know the shares are then undervalued and we should continue to hold them. Writing a put, holding the shares, then writing a call are the simplest examples of the use of options in fundamental investor portfolios. The use of options can get more complex from here. The amount paid for the option, measured by the implied volatility that results from setting the Black-Scholes option pricing model equal to the market price, allows for many interesting fundamental investing opportunities. There is some discussion of implied volatility as an asset class. We’ll dive into this topic in a later issue of Morningstar Advisor. There are some additional advantages that options can bring to an individual investor’s portfolio. For a client who is very risk tolerant and would consider using leverage, options provide an interesting benefit. The asymmetric payoff of options—exposure to the upside without exposure to the downside, or vice versa—means that a portfolio of purchased options can never be subject to a margin call. In many cases, the cost of this leverage can be effectively cheaper than the typical margin rates at retail brokers. So, for risk-seeking investors who want to move out on the capital market line past the market portfolio, doing so through options can protect against a temporary market mispricing driving their portfolio into bankruptcy (a margin call) and protect against permanent impairment of a large portion of their wealth. There are some tactical issues with using options. Bid-asked spreads are still murderous, but they have been steadily falling. Commissions for options are expensive at most brokerages, but these, too, have been declining. Taxes can be complex, and index options require special treatment, but there are also opportunities for tax-aware investment strategies using equity options. There are also potential portfolio margin requirement issues that need to be understood even for conservative strategies. For example, if an investor has sold the upside and bought downside protection on a stock or fund portfolio, not all brokerages will recognize those stocks and funds as margin for the call option representing the sale of the upside, especially if the securities are held in different accounts. Finally, as this article illustrates, the power and flexibility of options come at the price of complexity, and the tools to manage that complexity aren’t as commonly available as stock and fixed-income portfolio tools. But for advisors and investors willing to hone their skills, options can be used to effectively manage the risk and return of their investment portfolios. K As derivatives investing strategist, Philip Guziec, CFA, leads Morningstar’s option investment research. Morningstar takes a fundamental approach to options investing, as opposed to a trading approach based on “technical” analysis. To learn more about Morningstar’s options coverage, and how it can help you use options in your practice, go online to the Morningstar Options Home Page at: http://www.morningstar.com/Cover/Options.aspx. The articles “Visualizing Option Opportunities,” “The Morningstar Approach to Options,” and “The Morningstar Option Strategy Map” should be particularly helpful. 24 Morningstar Advisor Winter 2008

http://www.morningstar.com/Cover/Options.aspx

Morningstar Advisor - Winter 2008

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