options

After the Fall: What Next for Nvidia and AI, In the Light of DeepSeek

Scott BuchananLeave a comment

Anyone not living under a rock the last two weeks has heard of DeepSeek, the cheap Chinese knock-off of ChatGPT that was supposedly trained using much lower resources that most American Artificial Intelligence efforts have been using. The bearish narrative flowing from this is that AI users will be able to get along with far fewer of Nvidia’s expensive, powerful chips, and so Nvidia sales and profit margins will sag.

The stock market seems to be agreeing with this story. The Nvidia share price crashed with a mighty crash last Monday, and it has continued to trend downward since then, with plenty of zig-zags.

I am not an expert in this area, but have done a bit of reading. There seems to be an emerging consensus that DeepSeek got to where it got to largely by using what was already developed by ChatGPT and similar prior models. For this and other reasons, the claim for fantastic savings in model training has been largely discounted. DeepSeek did do a nice job making use of limited chip resources, but those advances will be incorporated into everyone else’s models now.

Concerns remain regarding built-in bias and censorship to support the Chinese communist government’s point of view, and regarding the safety of user data kept on servers in China. Even apart from nefarious purposes for collecting user data, ChatGPT has apparently been very sloppy in protecting user information:

Wiz Research has identified a publicly accessible ClickHouse database belonging to DeepSeek, which allows full control over database operations, including the ability to access internal data. The exposure includes over a million lines of log streams containing chat history, secret keys, backend details, and other highly sensitive information.

Shifting focus to Nvidia – – my take is that DeepSeek will have little impact on its sales. The bullish narrative is that the more efficient algos developed by DeepSeek will enable more players to enter the AI arena.

The big power users like Meta and Amazon and Google have moved beyond limited chatbots like ChatGPT or DeepSeek. They are aiming beyond “AI” to “AGI” (Artificial General Intelligence), that matches or surpasses human cognitive capabilities across a wide range of cognitive tasks. Zuck plans to replace mid-level software engineers at Meta with code-bots before the year is out.

For AGI they will still need gobs of high-end chips, and these companies show no signs of throttling back their efforts. Nvidia remains sold out through the end of 2025. I suspect that when the company reports earnings on Feb 26, it will continue to demonstrate high profits and project high earnings growth.

Its price to earnings is higher than its peers, but that appears to be justified by its earnings growth. For a growth stock, a key metric is price/earnings-growth (PEG), and by that standard, Nvidia looks downright cheap:

Source: Marc Gerstein on Seeking Alpha

How the fickle market will react to these realities, I have no idea.

The high volatility in the stock makes for high options premiums. I have been selling puts and covered calls to capture roughly 20% yields, at the expense of missing out on any rise in share price from here.

Disclaimer: Nothing here should be considered as advice to buy or sell any security.

Buying on Margin is Like an Option

Zachary Bartsch4 Comments

Over the winter break I was able to catch up on a lot of podcasts. I also began listening to the Marginal Revolution podcast (which is phenomenal). I especially enjoyed the final episode of season 1 about options and how many transactions can be characterized as giving someone an option. Here, the term option echoes a financial option. You pay today for the ability to do something in the future. In financial markets, you can purchase the right to buy or sell at a particular price in the future.

But lots of things count as options. Staying in the financial context, purchasing a stock gives you the option to sell that stock at the future spot price. So, in this way, something can be characterized as an option even though we are not accustomed to describing as such explicitly. More mundane transactions can also be interpreted as options. Assume that you buy a can opener. You are buying the option to have that tool on hand in the future and to open some shelf-stable food. You can choose to exercise the option simply by opening your kitchen drawer.

But financial options often include the possibility of losing money. It may be that your grocery purchases never include canned items and that you never have occasion to use your can opener. Maybe that’s a bad investment. You sunk your money into something that you never used. Except… You did in fact have the option to use the can opener. Maybe you had peace of mind that you were well prepared just in case a guest arrived with a can of something. Buying a can opener is like buying an option.

Returning to the realm of finance, let’s discuss buying on margin. Buying an asset on margin is when you borrow from your broker in order to purchase a financial asset. It’s not entirely free money. They have rules about the amount you can borrow and, of course, you must pay back the loan with interest.

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Funds Paying “Return of Capital” Give You (Sort of) Tax-Free Income

Scott Buchanan2 Comments

The stock of an individual company like AT&T, or a stock fund, often pays a dividend or distribution. Typically, these dividends are taxed as income. If you buy shares of a fund like MUNI that hold municipal bonds from U.S. states and cities, the dividends from that are not taxed by the feds (they are taxed on state income taxes). That’s nice, but the yield from a muni fund MUNI is only 3.3%, and the share price of MUNI drifts around with bond prices; it does not grow like the S&P500 stocks do.

What if there was a way to get highish dividends that are not taxed, at least not in the short term? There is. Funds classify their distributions or dividends in various categories. Net investment income or short-term capital gains are taxed like interest or ordinary income (highest rates). Qualified dividends or long-term capital gain returns are taxed at a lower rate. But “Return of Capital” (ROC) distributions are not taxed at all, when you receive them. (The accounting fiction is that ROC is simply your own investment money being handed back to you, rather than you getting interest or profit, which is why it is not taxed).

ROC only catches up with you when you sell your shares. Every dollar you pocket in ROC goes to lower the formal cost basis of your shares, so that increases the capital gains tax you pay when you sell.  Still, it can mean you defer paying taxes for many years, and when you do sell after many years, you will pay mainly long-term capital gains. Long-term capital gains have relatively low tax rates, and sometimes can be offset with capital losses elsewhere. So, this is a pretty good deal overall. All this only benefits you if you are holding these stocks in a taxable account, not in an IRA.

And, there are ways to not sell your shares, and hence never pay an inflated capital gains tax from all that ROC. One way not to sell your shares is to die (!). Your heirs inherit the funds at the current market value i (stepped-up basis”), without having to pay capital gains. So older folks do deliberately lard up their portfolios with ROC-paying funds or stocks, to leave to their heirs.

Another tactic is to donate the shares to charity. As I understand it, the donation gets valued at current market price, regardless of your cost basis. So, for instance, you might buy shares of XYZ fund at $100/share, collect say $50 in untaxed ROC over the next five years, and then donate the shares for a tax deduction at say $100/share (if their market price had not changed in five years). Obviously, this is only attractive if you wanted to make a charitable donation anyway.

OK, what are some funds or stocks that pay out ROC? There are number of funds which hold stocks, and write (sell) call options on them to generate income. (See here on selling options). Some (not all) of these funds pay out as mainly ROC, and are discussed here. SPYI and ETV are plain vanilla funds holding a basket of S&P500 type stocks, usually with a skew towards tech, and selling call options on them. (Or usually, selling options on an index like SPX or QQQ).  SPYI is currently paying about 11.5% yield, and ETV about 9%, both mainly ROC. ETV happens to be a closed-end fund, which can be good or bad, depending on whether you buy in when the share price is at a discount or premium to the asset value. Right now, ETV is at about a 5% discount, so it is a relatively good time to buy.

It is essential to note with these high yielding funds, the raw yield is practically meaningless. You have to look at total return, which factors in stock price over time as well as cash payout. The reason is that some funds “cheat” by paying huge yields, which sucks in investors, but those yields are not really earned by the fund, so those big payouts gradually deplete the fund’s assets.

FEPI holds an equally-weighted basket of fifteen tech stocks, and sell options on them. By selling options on individual stocks, the options income is huge; FEPI pays about 20% yield. The share price bounces around heavily, being so narrowly concentrated. If tech has a bad/good day, FEPI goes way down/up. QDTE also pays about 20%. It has a more novel strategy, selling “zero-day” options, which I won’t try to explain here. It has only been running about 6 months, but is doing OK.

A problem with all these option-selling funds is that their asset value goes down 10% if the underlying stocks go down 10%, but if stocks recover fast, the value of the funds typically do not recover as much. So, the share price of these funds keeps slipping below the price of a plain stock fund like SPY or QQQ. Now, if stocks go up (which they do most years), the price of an options fund can also go up, just not as much. The lag of these options fund is significant enough that on a total return basis (i.e. with dividends and stock price included), they usually lag behind just holding the stocks. Thus, the only reason to hold these funds is to harvest the tax-free ROC, or if you have a reason to want to generate steady income without selling off stocks.

Some 1-year total returns:

SPY        26.7%   Plain S&P 500  stock fund

SPYI       8.5%      Option fund

ETV        8.8%      Option fund

FEPI       20.2%   Option fund

QDPL     25.9%   Quadruple stock divi fund          

(Note, it is a little random that FEPI looked so good and SPYI and ETV looked poor in the past 12 months; that is not always the case. In the past 6 months, FEPI fared much worse than SPYI and ETV, which only lagged SPY by 1-2%). Some other newish option funds that pay mainly ROC are ISPY (8% yield, sells daily options, very little return lag) and three more with fairly low return drag: XDTE and QDTE (~20% yields, daily options on S&P500 and on NASDAQ 100); QYLG (6% yield; monthly options on half of NASDAQ 100).

Another fund I became aware of recently that pays mainly ROC is QDPL. It does not sell options, so it does not suffer the return lag the other funds do. It uses a futures strategy to take about 15% of the fund assets to garner roughly 4X the normal stock dividends of the S&P500 stocks. It only yields about 5.5%, but its total return keeps up pretty well with SPY. I like this one, and am including it in my portfolio with some of the options funds discussed above.

A whole other class of stocks that pay out mainly ROC is limited partnerships. These are common, e.g., among oil and gas pipeline companies like ET and EPD. These pay 7-8% and also are having strong share price appreciation. But they issue K-1 tax forms, which most mortals don’t want to deal with (I don’t).

As usual, this discussion does not constitute advice to buy or sell any security.

How to (Almost) Double Your Investing Returns 2. Buy Deep in the Money Calls

Scott Buchanan6 Comments

Last week we described a simple way to achieve roughly double investing returns on some asset class like an S&P 500 stock basket, or a narrow class of stocks such as semiconductors, or on some commodity like gold or oil. That way is to buy one of the many exchange-traded funds (ETFs) which use sophisticated derivatives to achieve a 2X or even 3X daily movement in their share prices, relative to the underlying asset. For instance, if the S&P 500 stocks move up by 2% on a given day, the SSO ETF will rise by 4%.

Of course, these leveraged funds will also go down two or three times as much. They also have a more subtle disadvantage, which is that when the markets go up and down a lot, they tend to lose value due to their daily reset mechanism.

In this post we describe a different way to achieve roughly double returns, which does not suffer from this volatility drag issue. This way is to buy long-dated deep in-the-money call options on a stock or a fund.

Say what? We have described how stock options work here and here. The reader who is unfamiliar with options should consult those prior articles.

A stock option is a contract to buy (if it is a call option) or to sell (if it is a put option) a given stock at some particular price (“strike price”), by some particular expiration date. Investors generally buy calls when they believe that the price of some stock or fund will go up.  For a call option with a strike price far below the current market price of a stock, the market price of the option will move up and down essentially 1:1 with the market price of the stock.

For instance, as I write this the market price of Apple is about $230. Suppose I think Apple is going to go up by say $40 in the next six months. One way for me to capture this gain is to invest $230 in buying Apple stock. The alternative propose here is to instead of buying the stock itself, buy, say, a call option with a strike price of $115 and an expiration date of January 17, 2025. The current market price of this option is about $119.

Other things being equal, we expect that the market value of this call option will go up by $40 if Apple itself goes up by $40. But we have invested only $119, rather than $230, so our return on our investment is roughly double with the option than by buying the stock itself.

There is a subtle cost to this approach. At a stock price of $230 and a strike price of $115, the intrinsic value of this call option is $115. But we pay an extra $3 of extrinsic value when we buy the option for $118. This extrinsic value will gradually decay to zero over the next six months.

Thus, if Apple went up by $40 within the next month or so, we could turn around and sell this call option for nearly $40 more than our purchase price. But if we wait for six months before selling it, we would only net $37 (i.e., $40 minus $3). This is still fine, but it illustrates that there is a steady cost of holding such options. This annualized cost is about equal to or slightly higher than the prevailing short term interest rate (5% /year). This option pricing makes sense, since an alternative way to control this many shares would be to borrow money at current interest rates (5%) and use those borrowed funds to buy Apple shares. Options and futures pricing is generally rational, to make things like this equivalent, or else there would be easy arbitrage profits available.

As a side comment, the reason I am focusing on deep in the money calls here is that the extrinsic premium you pay in buying the call gets lower the further away the strike price is (i.e. deeper in the money) from the current stock price. A deeper in the money call does cost you more up front, but net net its dollar movements up and down more closely track (1:1) the movements of the underlying stock. So, if I am not trying to guess right on any market timing, but simply want to get the equivalent of holding the underlying stock but tying up less money to do so, I find buying a call that is about 50% in the money generally works well.

How I Use Deep in the Money Call Options

I consider the technology-oriented stock fund QQQ to be a core holding in my portfolio, so I would like to stay exposed to its movements. But I might as well do this on a 2X basis, to make better use of my funds. I do hold some of the 2X ETF QLD. But if we experience a lot of market volatility, the price of QLD will suffer, as explained in our previous post.

As a more conservative approach here, I recently bought a deep in the money call on the QQQ ETF. As usual, I went for a call option with a strike price roughly half of the market price, with an expiration date 6-12 months away. When this gets close to expiration (May-June next year), I will “roll” it forward, by selling my existing call option, and buying a new one dated yet another 6-12 months further out. This takes little work and little decision making. I will pay the equivalent of about 5% annualized cost on the decay of the extrinsic option premium, but I come ahead as long as QQQ goes up more than 5% per year.

This is a little more work than just holding the 2X QLD ETF, but it gives me a bit more peace of mind, knowing I have done what I can to smooth out some of the risk there. Of course, if QQQ plunges along with the markets in general, I will be looking at double the losses. For that reason, I am taking some of the money I am saving by using these leveraged approaches, and stashing it in safe money market funds. In theory that should give me “dry powder” for buying more stocks after they drop. In practice, I may be too frozen with fear to make such clever purchases. But at any rate, I should not be appreciably worse off for having used these leveraged investments (2X funds or deep in the money calls).

Disclaimer: As usual, nothing here should be considered advice to buy or sell any investment.

Stock Options Tutorial 3. Selling Options to Generate Extra Income

Scott Buchanan3 Comments

In the first installment of this series on stock options, I focused on buying options, as a means to economically participate in the movement of a stock price up or down. If you guess correctly that say Apple stock will go up by 10% in the next two months, you can make much more money with less capital at risk by buying a call option than by buying Apple stock itself. Or if you guess correctly that Apple stock will go down by 10% in the next two months, you can make more money, with less risk, by buying a put option on Apple, then by selling the stock short.

In part two of the series, I discussed how options are priced, noting the difference between intrinsic value, and the time-dependent extrinsic value.

Here in part three, I will discuss the merits of selling, rather than buying options. This is the way I usually employ them, and this is what I would suggest to others who want to dip their toes in this pond.

Just to revisit a point made in the first article, I see two distinct approaches to trading options. Professional option traders typically make hundreds of smallish trades a year, with the expectation that most of them will lose some money, but that some will make big money. A key to success here is limiting the size of the losses on your losing trades. It helps to have nerves of steel. Some people have the temperament to enjoy this process, but I do not.

Selling Out of the Money Calls

Instead if spending my days hunched over a screen managing lots of trades, I would rather set up a few trades which may run over the course of 6 to 12 months, where I am fairly OK with any possible outcome from the trades. A typical example is if I bought a stock at say $100 a share, and it has gone up to $110 a share, and I will be OK with getting $120 a share for it; in this case I might sell a six-month call option on it for five dollars, at a strike price of $115. The strike price here is $5 “out of the money”, i.e., $5 above the current market price.

There are basically two possible outcomes here. If the price of the stock goes above $115, the person who bought the call option will likely exercise it and force me to sell him or her the stock for a price of $115. Between that, and the five dollars I got for selling the option period, I will have my total take of $120.

On the other hand, if the stock price languishes below $115, I will get to keep the stock, plus the five dollars I got for selling the option. That is not a ton of money, but it is 4.3% of $115. If at the end of the first six-month period I turned around and sold another, similar six-month call option which had the same outcome, now I have squeezed an 8.6% income out of holding the stock. If the stock itself pays say a 4% dividend, now I am making 12.6% a year. Considering the broader stock market only goes up an average of around 10% a year, this is pretty good money.

At this point, you should be asking yourself, if making money selling options is so easy, I have I heard of this before? What’s the catch?

The big catch is that by selling this call, I have forfeited the chance to participate in any further upside of the stock price, beyond my $120 ($155 + $5). If at the end of six months, the stock has soared to $140 a share, but I must sell it for a net take of $120, I am relatively worse off by selling the call. I have still made some money ($20) versus my original purchase price. However, if I had simply held the stock without selling a call option, I would have been ahead by $40 instead of $20. And now if I want to stay in the game with this stock, I have to turn around and buy it back for $140. This decision can involve irksome soul-searching and regrets.

There are two techniques are used to reduce these potential regrets. One is to only sell calls on say half of my holdings of a particular stock. That way, if the stock rockets up, I have the consolation of making the full profit on half my shares.


The other technique is to try to identify stocks that trade in a range. For instance, the price of oil tends to load up and down between about seven day and $90 a barrel, barring some geopolitical upset. and the price of major oil companies, like Chevron or ExxonMobil, likewise trade up and down within a certain range. If you sell calls on these companies when they are near the top of their range, it is less likely that the share price will exceed the strike price of your option. Or, if it does, and you have to sell your shares, there is a good chance that if you just wait a few months, you will be able to buy them back cheaper. On the other hand, a stock like Microsoft tends to just go up and up and up, so it would not be a good target for selling calls.

Some Personal Examples

From memory, I will recount two cases from my own trading, with the two different outcomes noted above. ExxonMobil stock has been largely priced between $95 and $115 per share, depending mainly on the price of oil. In early 2024, with the price of XOM around 117, I sold a call contract with a strike price of 120 and an expiration date in January, 2024. I think I got around $9 per share for selling this option. The next twelve months went by, and the price of XOM never got above 120, so nobody exercised this call contract against me, and so I simply kept the $9, and kept my XOM shares. Since each contract covers 100 shares, I pocketed $9 x 100= $900 from this exercise, covering 100 shares (approx. $12,000 worth) of XOM stock.

That was the good, here is a not so good: I bought some ARES (Ares Management Corporation) around February 2023 for (I think) around $80/share. For the next few months, the price wobbled between $75 and $90, while the broader S&P 500 stock index (lead by the big tech stocks) was rising smartly. I lost faith in ARES as a growth stock, but decided to at least squeeze some income out of it by selling a call option for about $10 at a strike price of $110 and a distant expiration of Dec 2024.

What then happened is ARES has taken off like a rocket, sitting today at $132/share. If it keeps up like this, it may be well over $150 by December, 2024. I will likely have to sell my 100 shares for $110 (the strike price), so I will get a total of $110 + $10 = $120 for my shares. That is far less than the current market value of these shares. I am not crying, though, since I have some more ARES shares that I did not sell calls on. Also, getting $120 for the shares I bought for $80 is OK with me. There is a saying on Wall Street about being too greedy, “Bulls make money, bears make money, pigs get slaughtered.”

Selling Puts

Briefly, selling out-of-the money puts is like selling calls, on the buy-side instead of the sell-side. It is a way to generate a little income, while garnering an advantageous purchase price, if things go as hoped. In my ARES example above, suppose my 100 shares get called away from me, when the market price is $150. I have various choices at that point. I could simply by a fresh 100 shares at $150, or I could get onto other investments. Or, if I were not happy about paying $150, I might sell a $140 put for say $6 per share. I would have to be OK with either of two outcomes: (1) either the price drops below $140 and the buyer of my put option forces me to buy it at $140 (in which case I need to have $140 x 100= $14,000 in cash available) , though net the stock will only cost me $140 – $6 = $134 ; or (2) the price stays above $140 and I simply pocket the $6 option premium.  And I have to be willing to live with the regret if ARES goes on to $180, in which case it would have been better to have simply bought shares at $150 instead of dinking around with options.

So, there is no one-size-fits-all approach. Again, I prefer to sell puts on companies that more trade in a range. For instance, gold tends to meander up and down – I have thought about it, but never got around to selling puts on gold companies at lows, and calls when they are high.

In Summary

I find judicious selling of calls and puts is a fairly tame way to make a little extra income on stocks. Also, it forces me to set some price targets for buying and selling. I have horrible selling discipline otherwise – I have a hard time making up my mind to buy a stock, but once I do, and once it goes up, I fall in love with it and don’t want to sell it (partly because lazy me doesn’t want to do the work to find a substitute). Selling calls is one way to force myself to set “OK” price targets for letting a stock go.

All that said, selling calls does forfeit participation in the full upside of a stock, and is probably not a good approach in general for growth-oriented tech stocks. Likewise, selling puts, instead of outright buying a stock, may lead to regrets if the stock price goes way up and gets away from you.

As usual, this discussion does not constitute advice to buy or sell any security.

Stock Options Tutorial 2. How Options Are Priced

Scott Buchanan5 Comments

This continues our occasional series on stock options for amateurs.

I find options to be a nice tool in my investing arsenal. The previous post in this series was Stock Options Tutorial 1. Options Fundamentals.  That post dealt with buying options, to provide simple examples. For reasons to explained in a future post, I usually prefer to sell options. Anyway, here we will look briefly at how options are priced. It is important to get an intuitive understanding of this, in order to be comfortable actually using options in your account.

The current price of an option, if you wanted to buy or sell it, is called the premium. There are two components that go into the premium, the intrinsic value and the extrinsic (or “time”) value:

Source: OptionAlpha

Intrinsic Value of Options

The intrinsic value is easy to figure out, once you understand it. It is simply how much you would profit if you owned the option, and decided to exercise it right now. For instance, if you owned a call with a strike price of $50, but the stock price is $55, you could exercise the call and force whoever sold you the call to sell you the stock at a price of $50/share; you could turn around and immediately sell that share for $55, pocketing $5/share. We say that the option in this case is $5 in the money, and the intrinsic value is $5.

If the stock price were $60, it would be $10 in the money; you could pocket $10/share for exercising it. If the stock price were say $90, the option would be $40 in the money, and so on.

However, if the stock price were $50 (the $50 option is “at the money”) or lower (option is “out of the money”), you would get no benefit from being able to purchase this stock for $50, and so the intrinsic value of the option would be zero.

With a put (which is an option to sell a stock at a particular price), this is all reversed. If the stock is $5 lower than the option strike price, the option is $5 in the money and has a $5 intrinsic value, since if you own it, you could say buy the stock at $45, and force the put option seller to buy it from you at $50/share:

Source: OptionAlpha

Extrinsic (Time) Value of Options

Suppose the current price of a stock is $50. And suppose you suspect its price may be above $50, say $60 sometime in the next month, so you would like to have the option of buying it at $50 sometime in the future, and then selling it into the market at (say) $60, for a quick, guaranteed profit of $10. Sounds great, yes?

Since a $50 call is right at the money (since the stock price is also $50), the intrinsic value of a $50 call is zero. Does this mean you could go out and buy a $50 call option for nothing? No, because the seller of the option is taking a risk by providing you that option. If the stock really does go to $60, he could be out the $10. Therefore, he will demand a higher price than the intrinsic price, to make it worth his while. This extra premium over the intrinsic premium is the extrinsic premium, which varies greatly with the time till expiration of the option.

If you wanted the option of buying the stock at $50 sometime in the next week, the option seller would charge only a small amount; after all, what are the odds that the stock will rise a lot in one week? However, if you wanted to extend that option period out to one year, he will charge you a high extrinsic premium, since there is a bigger chance that the stock could soar will over $50 sometime in that long timeframe.

Another way of framing this is, if you buy a $50 call option today with an expiration date a year from now, you will pay a high extrinsic value. But as the months roll by, and it gets closer to the expiration date, this extrinsic value or time premium will shrink down ever more quickly towards zero:

Source: QuantStackExchange, on Seeking Alpha

Now, computing the actual amount of the extrinsic value is really gnarly. The Black-Scholes model provides a theoretical value under idealized conditions, but for us amateurs, we pretty much have to just take what the market gives us. In deciding whether to buy or sell an option, I look at what the current market pricing is for it.

It turns out that an option which is priced at the money has the highest extrinsic value. As you get further into or out of the money, the extrinsic component of the total premium for the option diminishes. Below is one final graphic which pulls all this together:

Source: OptionTradingTips

The call option strike price is $25. The blue line shows the intrinsic value (labeled as “payoff at expiration”) at each stock price – this is zero at or below $25, and increases 1:1 as the stock price climbs above $25. The red curve shows the full market price of the option, including the extrinsic (time) premium. The spacing between the red and the blue lines shows the amount of the extrinsic premium. That spacing is greatest when the stock price is equal to the $25 strike price. The shaded areas specify the intrinsic and extrinsic values at a stock price of $27.

And (not shown here) as time passed and the option got closer to expiry, the extrinsic value would shrink (decay), and the red curve would creep closer and closer to the blue curve.

Stock Options Tutorial 1. Options Fundamentals

Scott Buchanan4 Comments

Put simply, a stock option is a contract to buy (if it is a call option) or to sell (if it is a put option) a given stock at some particular price (“strike price”), by some particular expiration date.

Example: Buying Apple Call Option Instead of the Stock


In a little more detail: if you buy a call option on a stock, that gives you the right to buy that stock at the strike price (“call” the stock away from some current stockholder).
For most American stocks the option holder can exercise this right at any time, up till the end of the expiration day. (For so-called European options, you can only exercise the option on the expiration date itself.)
Let’s jump into an example. As of late morning 11/27/2023 when I am writing this, the price of Apple stock is $190 per share.  Suppose I have a strong conviction that within the next month or so, Apple will go up by 10 dollars (5%) to $200/share.

One thing I can do is plunk down 100 x $190= $19,000 to buy 100 shares of Apple, and wait. If Apple does indeed reach my target price of $200 in some reasonable timeframe, and I sell it there, I will make a profit of 100 shares x $10 / share = $1000 on my initial investment of $19,000. That represents a 5.3% return on my investment.


But suppose because of some unexpected factor (Taiwan invasion?), that the price of Apple plunges by say 30% to $133/share, and remains there for the indefinite future. If I want to get my money out of this affair and move on, I would face a huge loss of 100 shares x (190-133)= $5,700 dollars on my large $19,000 investment.

Instead of buying the stock outright, I could buy a call option. There are a number of specific strategies and choices here, but to keep it simple, I could buy an Apple call option with a strike price of 190 (the current price of Apple) and an expiration date of say December 29, 2023. At the moment, that call option would cost me $3.80 per share, or $380 dollars for a standard options contract that involves 100 shares.


If Apple stock hits my price target of $200 sometime in the next month, I could exercise this option and purchase 100 Apple shares for $19,000 dollars, (100 x $ 190 strike price) and immediately sell them into the market 100 x $200/share = $20,000 dollars. That would give me a net profit of: (profit on stock buy & sell) minus (cost of call option) =  100 x ( ($200 – $190 ) – $3.80 ) = $620. That is a return of 163% on my $380 investment. Woo hoo!
(If I did not want to actually exercise the call, I could have sold it back into the options marketplace; the value of the call would have risen by somewhat less than $10 dollars since the time I bought it, so I could take my profit that way, without going through the cycle of actually buying the shares and immediately selling them.)

If Apple stock fails to rise by more than the $3.80 dollars a share that I paid for the call option, I will lose money on this trade. If Apple stays at or below 190, this call option expires valueless, and I will have lost 100% of my option purchase price. (If say two weeks goes by and the share price is hovering just below 190, this call option might still be worth something like $1.90/share, and I might choose to sell it and bail on this trade, to recover half of my $3.80 instead of risking the loss of all of it; there are many, many ways to trade options).

Now, in the event that Apple shares plunge by 30% and stay low indefinitely, I would only lose the $380 that the options cost me, instead of the $5,700 dollars I would lose if I had bought the stock outright.

This example demonstrates some of the benefits of buying stock options: You can make a huge return on your invested/risked capital if your stock price thesis plays out, and you can be shielded from any losses other than the cost of the option. The big weakness of this approach is that your hoped-for stock move must occur within a limited timeframe, before the expiration date, or else you can lose 100% of your investment. Folks who trade options for a living make lots and lots of small trades, knowing that they will lose on a significant percentage of these trades, hoping that their wins will outweigh their losses.

Buying Put Options for Hedging and Speculation

This has been a somewhat long-winded explanation of one way of utilizing options, namely, buying calls. Buying a put option, on the other hand, gives you the right to require that someone will buy a stock from you at the strike price (here, you are “putting” the stock to the person who sold you the option).

Puts are often used as for protective hedging. Suppose I own 100 shares of Apple stock that is currently valued at 190 dollars a share, and I want to protect against the effects of a possible plunging share price. As an example, I might buy a March 15, 2024 put with a strike price of 175, for $2.80. If Apple price falls, I would absorb the first 15 dollars per share of the losses, from 190 to the strike price of 175. However, that put would protect me against any further losses, since no matter how low the share price goes, I could sell my shares at $175. (Again, instead of actually selling my shares, I might sell the puts back into the market, since their value would have increased as Apple share price fell).
Buying puts in this manner is like buying insurance on your portfolio: it costs you a little bit per month, but prevents catastrophic losses.

Buying puts can also be used for speculative trading. Suppose I was convinced that Apple stock might fall well below $175 in the next three months. Without owning Apple shares, I might buy that March 2024 175 put for $2.80 per share, or $280 for a 100-share contract. If Apple share price went anywhere below (175 – 2.80 = 172.20), I would make money on this trade. If the price went back down to its recent low of 167, my net profit would be around 100 x (172.2 – 167) = $520. This would be nearly doubling the $280 I put into buying the puts. But again, if Apple price failed to fall as hoped, I might lose all of my $280 option purchase price.

Where to Find Options Prices

There are lots of YouTube tutorials on trading stock options. Here is quick ten-minute intro: Stock Options Explained, by The Plain Bagel. If you want to check out the prices of options, they are shown on websites like Yahoo Finance, Seeking Alpha (need to give email to sign in; you can ignore all the ads to make you purchase premium), and your own broker’s software.

I usually prefer to sell options, rather than buy them, but that is another post for another time. As usual, this discussion does not constitute advice to buy or sell any security.

Why Is Stock Market Volatility ( VIX ) So Low?

Scott Buchanan1 Comment

What is the VIX and why should you care? The CBOE Volatility Index (VIX) is a measure of the expected near-term price swings in the S&P 500 stock index (SPX). The VIX value is derived from the prices that market participants are willing to pay for options that expire roughly 30 days in the future. Typically, movements upward in VIX correspond to movements downward in broad market averages, since price volatility is usually associated with some “problem” cropping up. During market turbulence, the VIX can shoot up very high, very fast, with a percentage of change far higher than for stock prices.

The VIX is know as the “fear gauge,” since it provides a standardized measure of market volatility expectations. It is thus a number that conveys significant information about the attitudes of market participants. Also, it provides opportunities for investors to make (or lose) a lot of money quickly. You cannot invest directly in the VIX (it is just a calculated number), but you can buy/sell VIX futures and options on those futures. Also, there are convenient funds that buy (e.g., VXX) or short (e.g., SVIX) the VIX futures. Because the VIX makes much bigger percentage moves than stock themselves, you can make a killing with a modest investment, providing you get the timing right.

For instance, over the past twelve months, the SPY S&P 500 fund has gone up by about 18%, so $10,000 would have gone to $11,800. That’s pretty nice. But in that same period, SVIX went up by 143%, which would take $10,000 to $24,300 (see below).  (Nerdy notes: (a) SVIX shorts the VIX, so it generally goes up when VIX goes down, i.e., when stocks go up. (b) There is another factor with SVIX called the monthly roll, when tends to make it rise something like 2-4% a month on average. This monthly roll factor is layered on top of the rise and fall in SVIX value based on VIX level. So even if VIX is flat, SVIX may go up something like 30% in a year. )

SVIX and SPY share prices for the past year. Source: Seeking Alpha

Of course, the price swings on SVIX cut both ways. It is down hugely from its highs a month ago, as VIX has increased from roughly 14 to 20. You can go even more crazy by purchasing/shorting VIX-related funds like UVXY that are leveraged at more than 1.0X.

Even you were even more clever, you could have made even more, much more, by working VIX options. Also, if you just want to hedge your stock portfolio against sudden drops, it is often more economical to do that by buying (call) options on the VIX, than by buying (put) options on the stocks (e.g., SPX, SPY) themselves.

During long periods of market stability, the VIX tends to slowly drift downward, to an asymptote  somewhere in the 12-13 range. For example, in the five-year plot below, VIX spend much of 2019 around 13, then shot up over 80 within a month when the scope of the COVID pandemic became apparent. It then drifted downwards (with many spikes along the way, especially during the big bear market of 2022), getting down to around 14 for much of June-September of this year.

VIX Level for past five years. Source: Seeking Alpha.

It is notable for VIX to be this low, considering a number of serious current market concerns (the relatively high valuation of the stock market, stubborn inflation, hawkish fed, gridlock in Washington, etc.). And now with serious conflict in the Middle East resulting from the massive attacks on Israeli civilians, the VIX has so far only risen to 20.

A number of market commentators have noted the seemingly anomalously low level of the VIX, and have proffered various explanations. They observe that macroeconomic outlook continues to look probably OK. They also point to some fundamental changes in the stock market operations. One factor is the rise of zero-day options, very short-term stock options that expire within one day. More of the speculative action has gone to those options, with proportionately less in the month-out options that drive the VIX.

Also, the stock exchanges have implemented various “circuit-breakers,” which halt trading for specified time periods, if swings in stock prices get out of hand. This gives participants a chance to cool off and recalibrate, and not have to make frantic, quick (possibly losing) trades in order to protect themselves. Here is a diagram illustrating these circuit breakers, which are triggered by big moves in the broad S&P 500 stock average:

 Source: Seeking Alpha, article by Christopher Robb

There are also Limit Up/Limit Down (LULD) rules in place that temporarily halt trading in an individual stock if its price swings exceed some designated band.  is designed to stop excess volatility in a single stock.  With these protective circuit-breakers in place, market participants seem less worried about huge price swings coming at them, and hence may feel less of a need to “buy insurance” by purchasing options. This suppression of stock option prices in turn leads to a lower calculated VIX.

As usual, this blog post is not meant to be advice to buy or sell any security. (And seriously, the “never bet more than you can afford to lose” rule applies doubly with the high-volatility products discussed here).