Unlock the secrets of smart stock exits and options trading with the formidable expertise of Steve Davenport and his co-host Clem Miller. In a spirited exchange, we peel back the layers of using call options to gracefully bow out of stock positions, all while potentially padding your returns and softening the tax blow.
Steve guides us on selecting the right options that go well with your target prices and volatility—especially when earnings announcements loom large on the horizon. We don't shy away from potential behavioral pitfalls either, such as the sting of watching a stock ascend after you've sold your options. We offer advice on selling in increments to soothe any seller's remorse and smartly manage opportunity costs.
As the conversation deepens, we wade into the complex world of volatility and its influence on options trading, where the numbers tell only half the story. Here, volatility is a dance of mathematics and personal risk appetites, played out against the backdrop of life's major financial goals.
As we wrap up, we scrutinize the tug-of-war between retail and institutional traders and dissect the tell-tale signs of an overvalued stock. For investors keen on refining their strategy and navigating the markets with finesse, this episode is an essential listen.
Unlock the secrets of smart stock exits and options trading with the formidable expertise of Steve Davenport and his co-host Clem Miller. In a spirited exchange, we peel back the layers of using call options to gracefully bow out of stock positions, all while potentially padding your returns and softening the tax blow.
Steve guides us on selecting the right options that go well with your target prices and volatility—especially when earnings announcements loom large on the horizon. We don't shy away from potential behavioral pitfalls either, such as the sting of watching a stock ascend after you've sold your options. We offer advice on selling in increments to soothe any seller's remorse and smartly manage opportunity costs.
As the conversation deepens, we wade into the complex world of volatility and its influence on options trading, where the numbers tell only half the story. Here, volatility is a dance of mathematics and personal risk appetites, played out against the backdrop of life's major financial goals.
As we wrap up, we scrutinize the tug-of-war between retail and institutional traders and dissect the tell-tale signs of an overvalued stock. For investors keen on refining their strategy and navigating the markets with finesse, this episode is an essential listen.
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Clem Miller:
Hello everybody, welcome to Skeptics Guide to Investing with Steve Davenport and myself, clem Miller. Today we're going to be talking about using options to exit positions. As many of you know probably all of you know markets have been reaching highs recently stock markets and it leads to the question at what point should one exit the market as a whole or individual positions? Today we're going to talk to our options expert, steve, about how you use options to actually exit positions. With that question, steve, how would one go about using options to exit?
Steve Davenport:
Options have two different types. There's a put option, which gives you the ability to sell, and there's a call option, which gives you the ability to buy. The way that you do this when you want to sell something is you would sell a call option, which would give the person who's buying the call option the right, but not the obligation, to buy at a price for a period of time at a level in the future. For example, if we have Nvidia trading at 9 something, 25, and you said I think that it's going to have trouble going through a thousand, but if it does, I'd be willing to sell at that price. You look and you say what options are out there for Nvidia? Nvidia has a lot of volatility, so you're going to get compensated very well for this. You look and say, okay, I'm going to sell a thousand level or an option priced at a thousand for Nvidia and I'm going to do this for three months and I'm going to collect $50, $100. It's really just the concept that you're taking the price and you're getting paid the premium. Now it's really about trying to instill some discipline. When you think about selling, there's really always trouble, and that trouble is taxes.
Steve Davenport:
I think that the simplest concept is that you want to sell your stock, not all of it. You're usually trimming it at some price in the future and each option controls 100 shares. In this example, with the price of Nvidia being so high and people may not have 100 shares and that may make it hard for them to do this strategy, the idea is put an option out there, get paid and if you hit that price you're satisfied. If you don't hit that price, then you don't sell it and you just collect the premium. In any example let's say that Nvidia was 910, and you put out an option at a thousand and it's got a July expiration then if it goes up $90 more dollars or 10%, then you'd say, hey, I've paid. If capital gains are 15% or 20%, I've saved 10% of it by the increase in the price plus the premium. That's pretty good. You're not worried as much about the impact on the taxes you have to pay, because the appreciation makes up some of that difference.
Clem Miller:
So, Steve, what's the downside really to doing that? It sounds like there's a lot of upside, especially on the tax front, but what's the downside?
Steve Davenport:
The downside is that the stock just moves down quickly and then you would have wished it sold at 910. People have this perception when they see a price and they don't execute at all. They don't sell a call, they don't sell any shares and they just sit and watch. And after a while people start to realize, hey, could I have handled this differently? Do we have choices as investors? Are we always learning? And I think that's the key Are you getting better at making decisions and does your process have some disciplines in place?
Steve Davenport:
And so when a position gets look at NVIDIA up year re you're date up almost 90%. It's had an unbelievable run. It's a great company, we all agree with that. But there is a point at which you sell. I want to say nobody goes broke selling winners, right, they're taking profits and redeploying them will not solve all your timing questions, but it's a start and that's how we look at the reason to use options. There are multiple reasons. One is a return enhancer, one is a risk reducer. But the other issue is if the stock goes down from here, will you have regret?
Steve Davenport:
And that's what we're trying to minimize regret, maximize return and reduce risk. I hope that we're all big boys and girls and we all realize that we can make mistakes with the use of options. What you're trying to do is mitigate some of those mistakes.
Clem Miller:
So you already mentioned that it helps with both risk and return. It reduces risk and also enhances return. But, steve, how do you actually choose the option that you want to use? Is it volatility or is it some other factor?
Steve Davenport:
Well, I like to look at target prices. I also like to look at whether the person feels that a certain price is what they'd be satisfied with. If they bought it at $400 and it gets to $1,000 150%, return feels very good. So we look at volatility as an indicator because when you see the volatility, you know that the price of the option is the highest when the volatility is the highest. So if I'm comparing two options and one has a volatility of 48% and the other has a volatility of 55%. I look at the historic wall for Nvidia and it's 45. I know that that 48 is better than the 45 average, but that 55 really stands out. I look for volatility and what usually happens is around earnings announcements, volatility goes up. Yes, around earnings, the price could go up and you could.
Steve Davenport:
One of the risks that I didn't mention previously is it could go above that price. If you're at a thousand and it goes to $1100, on the next earnings call you're going to say I sold out at a thousand, I got paid 50 or 60 dollars in premium, but now the stock's 1100, which leads me to my original comment that we've tried to write on some amount of not the whole amount of shares you own so that you still participate with some of your shares, but some of your shares have been sold at a price. That's when we talk about opportunity cost. There's an opportunity that you missed. There are opportunities out there for names. For example, like we talked about in other podcasts, like Tesla, there's a huge opportunity cost that when you could have bought that two or three years ago and you would have a great return.
Steve Davenport:
But there are a lot of things you do and don't buy certain names If you can't explain or understand how the price is going to be delivered to you in terms of growth in sales, growth in profitability. With this example, I would like people to think there are always opportunity costs and as long as you're aware of them, you feel much better in terms of your results.
Clem Miller:
Steve. Tesla is a great example of a lot of volatility, but I want to make sure you and I understand what volatility is. I think our audience intuitively understands volatility, but maybe doesn't understand from an investment perspective what that exactly is. I'm wondering if you can share with the audience what we, as investment professionals, consider volatility.
Steve Davenport:
Sure, volatility is typically the standard deviation of the price, meaning the first derivative of price is return. The second derivative of the price equation is volatility. It tells you how the stock is going to behave over a longer period. So when you look at, there's really many definitions. One definition of volatility is I don't want to lose money. I lose money, I have a negative return. That's negative volatility and I don't want that.
Clem Miller:
Right.
Steve Davenport:
Very hard to eliminate that there's volatility in terms of how am I relative to my benchmark, am I above my benchmark, below my benchmark and relative performance. And I think there's absolute and then there's relative. And then I think that volatility has a lot to do with your own personal circumstances. So if you are depending on that money for a down payment on a house, if you're putting that money at risk for your children's college fund, the volatility that you're willing to absorb or experience goes down as you get closer to that kid going to college. So therefore, you don't want to make a mistake and you will try to obtain less volatility, meaning less variation in the price of the object or the stock. So I think that we all have different definitions of volatility, but I would say the most consistent one is the second derivative of price, or the standard deviation of a given return.
Clem Miller:
Yeah. So, Steve, just to stay on that point about volatility for a second, since someone, our audience may not understand derivatives, first and second derivatives. I have in my mind and maybe our audience should too the standard bell curve, the bell curve being the curve that looks like the Liberty Bell in Philadelphia, where you have a bulge in the middle that goes up, which is the average, and then you have the curve curving down to the left and you have the curve curving down to the right. Well, it's nice to have returns off on the curve to the right, because it means higher returns, but what you're trying to protect against is a lot of negative returns on the left side of the bell curve, because then you're well below what the average returns could be. So that's what we're talking about here, just visually, if you can visualize that bell curve. We don't want to be on the left side where you have all those negative returns.
Steve Davenport:
Right, I think about things in terms of Excel. So when I say I have a column of returns going back three years weekly returns or daily returns and I click and say equals standard dev of all of the items in the column, and then that gives you a number and then you say is this number weekly, monthly or annualized? And then you apply a number to annualize it. So it's a mathematical concept. But what I was trying to get into is the personal concept of what volatility is to the individual. I agree the bell curve.
Steve Davenport:
The reason I don't like to talk about the bell curve is that I believe we know that returns are skewed towards the positive side. So while a bell curve is a simple concept and a good idea, it's somewhat misleading and therefore I don't think any measure of return or of volatility is perfect. Right, I like to give people more answers that are really relative to their own lifestyle and their own situations, because then they can understand Iit better. All right, I'm selling nvidia entity that has a lot of volatility, good and bad and then I'm putting it into treasuries and those treasuries have guaranteed me that they will return what I or short term or cash If I'm not exposed to anything but inflation and I think I understand what inflation is then I can live with that for the next two or three months.
Steve Davenport:
When I was young, we just bought a house, I was selling stocks and putting it in cash and it made you feel very good when, on the day of your closing, the market's down two or three percent and all of your money is sitting there in cash and you're able to make the transaction happen where the way want to. Yeah.
Clem Miller:
So, Steve, when I'm sure people are looking at NVIDIA or other stocks and are thinking, well, when is it a good time to sell? After all price targets? As prices go up, people tend to adjust their price targets because they think, well, in Vidya's reach this point, it's going to go up even more. So how do you address that?
Steve Davenport:
I think that one of the the biggest issues with people is that once they see a price, they can't accept the price that's lower. So we have a perception issue and it's a behavioral issue where people are just always wanting something more. You say I'm happy if this goes to a thousand, I'll sell it a thousand, but if you're at a thousand fifty, suddenly the thousand doesn't feel that good. So it's really working with against your biases, which is your perception changes. You say, oh, look at this new product, look at this new application for AI and look at how it's going to lead to more change. There is always going to be positive and negative events and we tend to have a confidence bias that we think we understand and we think the past is the predictor of the future.
Steve Davenport:
I think all of these things. It's very hard for trees to grow to the sky. It's very hard for things to keep going up when there is reasonable people who look and say I've taken my profit, now I'm going on to other ideas. There's a retail weakness, which is when you see retail traders dominating a particular name at a time and you see institutional traders or buyers starting to step back and you say, hey, 80% of the buying is retail. Now that's usually an indicator that the stock may have peaked.
Steve Davenport:
The example of JP Morgan when the shoe shine boy tells him what stock he should buy, he realizes it's probably time to get out of this market. I think that people just have to be practical and say I can't always buy things because I have a fear of FOMO, fear of missing out. I should be buying things that I understand and I want to hold for a long time and then, if it performs the way I expected and it gives me the result I wanted, which is I want to grow this asset so that I can afford to pay for my child's college or car or house, when you get to the target and you need, it's wise to just take some chips off the table and go to another place where you think that you'll be fairly compensated. So I think it's a very hard topic and this is one of the things that I don't think there is a clear answer here.
Clem Miller:
But do you always do this in your portfolio or are you selective about using options?
Steve Davenport:
No, this is something that you apply as needed and when you're having trouble figuring out what to do and how to handle a stock, this is one solution that should be in your toolbag. I think that when you think of all of the things that you can do I can sell, I can hedge, I can write calls this should be one of the things you think about, and whether it makes sense. Every situation is different for every client and every investor, so what I would say is let's just make sure that this is a tool at your disposal so that you have a chance to eliminate some of that regret. I think if it goes up to 1,050 and then comes back down to 800, not having sold that call will feel very hard for you to think about it as a choice. On the multiple choice of what to do with investing to try to manage your risk and manage your return, it always helps to take some profits and allow yourself some choices in terms of other things to invest in.
Clem Miller:
So, Steve, how do our listeners actually get started with options? They may not know where to begin.
Steve Davenport:
So first year account has to be set up for options so you can look at the firm. You have your assets, custody, that and there's usually an option standardized option agreement that you must sign. That says you understand how options work and the risk associated with the option. I think it's a good way for people, even if they don't use options, go through the process, learn about them, set up your account for them and start slow. Start slow and grow your knowledge. It helps you in the end. If you ever needed to do something, you're set up to do it. I'm not recommending these for everyone. I don't think they're right for people who don't understand it and read the document and say I don't get this, then it's not for you. I think that for some investors, these should be a tool that you have and the way you set it up is talk to your existing advisor or talk to your existing custodian and set your count up for option.
Clem Miller:
So, Steve, I'm forging around in our mailbag and I'm pulling out one here on options. Do you think now is a particularly good time to use options?
Steve Davenport:
Yes, I think that, in terms of the move we've had in the markets, I believe that this move has been prolonged and has reached a point where it's not fully discounting all the possibilities.
Steve Davenport:
So when I see the 52-week highs that we're hitting and I see some of the level of disparity between the Magnificent Seven and other names, these are all signals that there perhaps is a good time for you to sell calls, the buy-pots, or to hedge. So I would say, yes, this is a good time to use those and I would recommend people, even if they don't end up using them. Understanding them is going to make you a better investor and ultimately allow you to have more flexibility with how you want to manage. One strategy many people use is to sell calls in the next year. So if we're in 2024 and I sell a January 2025 option, I'm putting that trade into the next tax year and by doing it in January, I'm not going to actually pay the capital gains on that if it hits until April of 26. So it really allows you to defer into the future and manage your last aspect of your results, which is taxes.
Clem Miller:
So Steve in 30 seconds or less. What are the takeaways that our listeners should take from this episode?
Steve Davenport:
So options are one tool that an investor should use to help manage their overall portfolio. Discipline matters, and when you use options like this, it instills a discipline that says I've identified a price, I feel comfortable with that price and I'm willing to let my shares go with that price. Past does not predict the future. Just because it's run from 600 to 900 is not mean that it's going to run from 900 to 1200. There is a caveat that you always say the past does not predict the future. And then the last item is you never go broke taking profits. My father was a tax accountant and he used to say if you keep taking profits, you're always going to be managing your cash flow, and that's ultimately what you want is to have more resources applied to more areas of the market so that you can do well with your money. So I'd say that keep it simple and understand what you're doing and learn. Those are principles that apply to everyone.
Clem Miller:
So, steve, thank you very much for this amazing lesson on the use of options in this kind of market, and we thank all of our listeners for tuning in and listening to our podcasts. So if you like these podcasts, make sure to like them and to subscribe, and we look forward to sharing with you on a future episode of Skeptics Guide to Investing. Thanks, everybody.