Reverse Convert Redux--Options Are Not a Zero-Sum Game
Let's clear up a myth about options.
Investing Specialists
On June 16 I wrote an article expanding on a piece on page C1 of The Wall Street Journal entitled "Reverse Converts: A Nest Egg Slasher." Apparently this topic has been rattling around the financial services blogosphere, and a financial blogger quoted me as part of a series of posts on reverse converts.
The blogosphere discussions about reverse converts have centered around two issues:
1. The morality and regulation of reverse converts and financial services in general;
2. The structure and value of reverse converts as investment vehicles.
I'm not going to dive into the discussion about the morality or regulation of reverse converts, although for those that are curious about my general thoughts on the issue, suffice it to say that I am one of the few people still willing to publicly admit to being a staunch free-market fundamentalist.
I will, however, spend some time discussing the issue of the usefulness of reverse converts or put options as an investment vehicle. To start with, the author of this article made the following comment:
"The problem with reverse converts isn't that they're too risky, it's that they're a transfer of wealth from the client to the broker. This is true in general whenever a stockbroker puts a client into an options trade: options, being derivatives, are a zero-sum game, and the options game is very profitable for the sell side. It's simply a truism, then, to say that the buy side, in aggregate, loses money whenever it dips into the options market." (the italics are my addition).
Let me make this perfectly clear. The statement above is patently false. Some derivatives have zero-sum characteristics, and some do not. Equity options specifically are not a zero sum game. Generally, derivatives contain much of the investment characteristics of the underlying security from which they are derived.
Upside or Downside, Options Include Market Drift
Let's start by explaining the mechanism by which the stock market generates return over time. Many layers of abstraction are typically painted over this basic system, but at its core, investors exchange their cash for stock in a company, and the company invests that cash and generates earnings. Assuming the accountants are doing their jobs, those earnings eventually turn into cash flow that piles up on the balance sheet. At some point, the cash is reflected in the share price of the company or the cash is paid to investors in the form of dividends. The net of all this is that stock investments, on average, generate returns over time.
Most estimates of historical and projected long-term returns to the stock market, in aggregate, hover around 10%. Simplistically, investors buying a basket of stocks and holding them for a long time--and by a long time we mean 30 years or so--generally receive around 10% return on their investment. This 10% return is called the market "drift" by statisticians. We all know that the 10% return of the stock market is "lumpy," with returns varying from 25% one year to negative 10% the next.
Equity or index options are based on the underlying shares of the companies, and as such, the call option and put option payoffs are impacted by the long-term market return. We think of call options as the upside of a stock price from some given strike, and put options as the downside of the stock price from the strike price. Bullish strategies get a positive impact from market return, and bearish strategies get a negative impact from the market return. So, if you take a bullish position by continuously buying call options, over time the payoff (upside) on the call options will be higher because it includes the average return of the market. If you take a bullish position by continuously selling puts, over time the payoff (downside) on the puts will be smaller because it includes the impact of the market return. Just like a stock price today has to be lower than the expectation for the future by the amount of the expected return, the price of the options has to reflect expected returns. Calls are cheaper than their long-term average payoffs, and puts are more expensive than their long-term average payoffs.
A more arcane way of explaining how stock returns flow through into options is through the no-arbitrage principle. Call option and put option prices are tied together to the present value of the future stock price discounted at the prevailing "risk-free" interest rate. If this relationship doesn't hold, arbitrageurs can buy a call, sell a put, and short a stock (or visa versa), and make a risk-free profit. The relationship between calls and puts actually makes option prices independent of the underlying stock price. As the stock price moves, so do the option prices, but the option prices reflect only the uncertainty about the future moves of the stock price relative to the current stock price, and the current stock price is the only way the expected future return is transferred to the options. Regardless of the uncertainty around the price of the stock, the market drift drives the final payout of both the call and the put options.
Option Investment Performance
Even if my explanations above don't make a great deal of sense (or any sense, for that matter), actual investing results should provide sufficient proof. The Chicago Board Options Exchange (CBOE) offers a series of index-option-based investment products. These products are the low-cost passive investing execution of option strategies. The most straightforward of these is the "S&P 500 buy/write index." The index buys the S&P 500 index and continuously writes one-month "covered" calls. A covered call is actually the exact same payout as writing a put, so this is really a put-writing strategy. This article provides a complete analysis of the performance of this investment strategy from 1988 to 2006. In short, this strategy provides returns that are close to the S&P 500 but with reduced volatility. These data alone are proof enough that not all option strategies are a zero-sum game.
In addition to the passive buy-write strategies, there are well-regarded buy side mutual funds that use options on individual stocks, such as Hussman Strategic Growth (HSGFX) or Gateway A funds (GATEX).
Regardless of your thoughts about the cost to the investor of using option products, it is clear that if the underlying security is a stock or an index, options are not a zero-sum game.
Other Benefits of Options and Derivatives for Individual Investors
Now that we've established that market return characteristics of securities are transferred to the options on those securities, let's discuss the other ways in which options and other derivatives can be useful to investors.
The range of option strike prices available allows investors to tailor their risk exposure to a stock or index. For example, let's say an investor wants market exposure but is very averse to large losses. That investor can buy an out-of-the-money put as a hedge to their portfolio, or even implement a costless collar, selling an out-of-the-money call option to buy an out-of-the-money put option. This allows them to invest without the mental anguish of worrying about "losing everything." A put option is just like an insurance policy, and people buy insurance policies because they dislike the exposure to highly negative outcomes, like having their car totaled in a car wreck or having their house burn down without the money to rebuild it.
Options also have a variety of strike prices, allowing investors to amplify their returns by taking exposure to the specific type of return they most expect. If a stock investor expects a very large move in a stock, he can buy an out-of-the-money call option. If a stock investor thinks there is a particular floor in the price of a stock, he can capitalize on that knowledge by selling an out-of-the-money put.
Other types of derivatives are similar to options in transferring underlying characteristics. For example, stock index futures are simply leveraged bets on a stock index. In general, they simply amplify the returns of the underlying index, both positive and negative. Since the underlying index has a long-term expected return that exceeds the interest component, so too does the futures contract.
Sure, there are some derivatives that are zero-sum in nature, but even these securities can have diversification benefits, reducing volatility in a portfolio and producing cash to invest with other security types posing the best return opportunities.
Finally, even for zero-sum investments, transferring risk from the most to least risk-averse is a form of value creation.
Brokerages, Banks, and Expenses
Moving beyond the investment value of options and other derivatives, the blogger comments that "the options game is very profitable for the sell side" is sufficient reason to criticize the use of options. This is a half-truth, because option transaction costs in the form of bid-asked spreads accrue largely to option market makers, many of whom are "buy side." Ignoring the market makers, broker transaction costs are a drag on investors, and transaction costs are typically higher by many measures on derivative transactions, both in brokerage commissions and bid-asked spread. I rail against high commissions and wide trading spreads as much as the next guy, and investors should certainly keep an eye on those costs and fight them. However, let's put transaction costs into perspective. Prior to 1975, stock transaction costs were as high as $0.82 per share! Most open-end mutual funds charge more than 1% of assets annually. Similarly, investment advisors can charge as much as 1% of assets annually. I'm quite certain that the aggregate payouts on insurance policies are less than the aggregate premiums paid, reflecting both the costs of writing the policies and the profit for the insurance companies, but few suggest that insurance is a bad investment (although I refuse to insure anything worth less than 1% of my liquid net worth). Lower-volume products like options and derivatives will always have higher transaction costs--it is the nature of a lower-volume business. The question investors need to ask themselves is, after costs, does the investment add value for them.
As I wrote in my original article on this topic, the sales of reverse converts can be deceptive. However, to keep my litany of cliches rolling, let's not throw the baby out with the bath water. Not all derivatives are a zero-sum game. Equity options are not a zero-sum game.
If we could analyze the returns to all buyers of reverse converts, and those who held the underlying shares when put to them, their aggregate portfolio returns may well be better off over time than if they had bought treasuries or simple highly rated bonds.
If you are interested in further exploring options strategies, I'd encourage you to download a free copy of The Morningstar Guide to Option Investing.
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