New mini options unveiled this week enable investors to bet on high-priced stocks for much less than the cost of a standard stock option.
The Chicago Board of Exchange on Monday launched a series of mini options that trade just like standard options, but each mini options contract represents just 10 shares of the underlying stock instead of the 100 shares in a standard options contract.
Mini options are being offered in five high-priced issues popular among retail investors: Apple Inc. (Nasdaq: AAPL), Amazon.com Inc. (Nasdaq: AMZN), Google Inc. (Nasdaq: GOOG), the SPDR Gold Trust (NYSE: GLD) and the SPDR S&P 500 ETF Trust (NYSE: SPY). If the new mini options catch on, more names will be offered.
The idea behind mini options is to give investors with smaller accounts the opportunity to use various options strategies to improve their investment performance without risking large amounts of investment capital. The five tickers chosen for the initial mini option launch all trade above $100/share and are all widely held by individual investors.
Because of the high share price, retail investors usually trade odd lots – amounts less than the 100-share "round lot" – in these names.
A 100-share round lot of Google would cost more than $81,000 at today's price, putting it well beyond the reach of most individual investors. A 10-share odd lot costs $8,100.
An investor who owns 10 shares of Google could use mini options to completely hedge a position or to generate income by writing a covered call.
How to Use Mini Options
Before the introduction of mini options, an investor with only 10 shares of Google could not buy an out-of-the-money put to hedge a position or write a call option against shares without incurring unreasonable risk.
Let's look at the example of an investor – let's call her Sue – with 10 shares of Google in an account with a total value of $25,000.
As of Wednesday afternoon, Google shares are trading around $812. If Sue writes a standard April 830 call option, selling the right to purchase 100 shares of Google at $830 between now and April 19, 2013, she will get $1,690 as an option premium.
Nice job, Sue! But suppose Google shares suddenly rocket off to $840 and the person who bought the call option decides to "call" or exercise his right to buy 100 shares of Google at $830 from Sue?
Sue has to deliver 100 shares of Google to the buyer. But she owns only 10 shares. Sue must purchase another 90 shares of Google in the market at the market price – now $840 – for a total cost of $75,600, three times the value of her entire account.
Even assuming Sue can somehow raise the funds she needs to buy the extra 90 shares, she is still going to be hit with a net loss of $900 on the 90 shares she had to buy at $840 to make good delivery – before commissions, taxes, etc. And that is assuming she can get the 90 shares at $840.
Until Sue can purchase those 90 shares of Google, her risk is open-ended and unlimited.
But if Sue were to write a mini call option against her 10 shares of Google, she would be perfectly covered. On Wednesday afternoon, Sue can get an option premium of $169.00 on the sale of an April 830 Google mini call option.
If we again assume that Google rises to $840 and the buyer of the mini call option exercises his right to buy 10 shares of Google at $830, Sue delivers her 10 shares and that is the end of it. Because of the option premium she received from selling the mini call option, it is as if Sue has sold her Google for a price of $846.90 (the $830 the buyer pays for each share plus the $16.90 option premium paid for the mini call option).
This is a low-risk way for Sue – or any other savvy investor – to generate monthly income. If Sue sold the April 830 Google mini call option as above but, this time, Google shares do not hit $830 before April 19, the mini option expires worthless and Sue pockets the $169.00 option premium she received. Sue can then write another covered mini call option for May and do it all over again.
Or let's suppose Sue originally bought her 10 shares of Google at $770 and after selling an April 830 mini call option at $16.90, Google shares tank. Sue has reduced her cost basis for her Google position by the $16.90 she received from the sale of the option.
Sue will not be losing money until Google falls below $753.10, which gives her a bigger cushion to ride out the ups and downs of being a long-term investor.
As you can see from the examples above, mini options give investors with smaller accounts the tools they need to generate additional income and reduce risk in some of the high-priced shares they own as odd lots.
To trade mini options, investors must open an options account with their broker. Investors should be sure they are authorized to write covered calls when they set up their options account so they can take advantage of this very conservative, income-generating strategy.
Mini options trade exactly the same way as standard options do. But, because they are new, they are available only for the five tickers listed above and they are less liquid than standard options, which are widely used by institutional investors to manage risk and to generate income.
But once individual investors realize how useful mini options can be in improving their investment performance, we think they will become much more popular and that demand for new mini option names will grow.
Related Articles and News:
- Money Morning:
Options Trading Strategies: Taking the Mystery Out of Puts and Calls
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- RIA Biz:
TD, Schwab and Pershing RIA units embrace mini-option mania to hedge Google, Apple, ETFs
- The Wall Street Journal:
Mini Options See "Respectable' Start
U.S. options exchanges to launch "mini" options on five securities