There are many things that scare investors, news, uncertainty, penny stocks, but nothing seems to scare investors more that options. What makes them so scary is simply the lack of understanding most investors have in using them. In this article we will look at three very simple and risk averse ways that investors can use options to give them more choices in their portfolios. To get started let’s look at some simple definitions that we can refer back to:
The right to buy a set stock at a set price on or before a set date in exchange for a premium paid.
The obligation to sell a set stock at a set price on or before a set date in exchange for a premium received
The right to sell a set stock at a set price on or before a set date in exchange for a premium paid.
The obligation to buy a set stock at a set price on or before a set date in exchange for a premium received.
Strategy #1: Protective Put – Options as Insurance
Sometimes due to special circumstances, some investors have stock that they would like to hold onto regardless of price movement. While we generally believe it is best to place a stop loss on positions and have previously written articles about drawing a line in the sand on investments, not everyone wants to have a sell strategy on their long term investments. The question then becomes what to do in times of unknown and possible market volatility? Sometimes there is an earnings announcements, impending litigation, or some other factor that can cause unpredictable market swings and cause a large drain on the position. One way of mitigating this risk is to purchase an insurance policy on that stock position by purchasing a Put option. Looking at the definition above the put option would give the investor the ability sell a set stock at a set price on or before a set date, essentially increasing in value as the underlying asset decreases in value. Here is an example:
An investor owns 100 shares of XYZ stock trading at $80 per share with a cost basis of $65. The investor has no interest in selling these shares and incurring a short term capital gain, and the investor has a long term target of $100 per share. In this case the investor wants to make sure that some of the profit is protected in case of a sharp decline but be able to ride out those declines with minimal exposure. An example of this would be that for insurance against the position, the investor could purchase a 3 month $76 Put option for $1. The Put option would now increase in value if the stock drops and protect the overall investment. Since the current price if the stock is $80 and the investor is purchasing a $76 put we can think of this as a $4 deductible on the insurance policy. Just like traditional insurance, the larger the deductible the smaller the premium paid. So the total cost ($4 deductible + $1 premium) is only $5 and would protect the investor for the next three months. If the stock continues to rise and does not fall, then the investor has only spent $1 to ride out the volatile period of their position.
Strategy #2 – Buying Stocks at a Discount
Everyone loves to buy things on sale; so, why not buy our stocks and ETF’s on sale too? If an investor is interested in accumulating shares of a particular stock but wants to buy them at a lower price, why not sell options and get paid to acquire them? If you look above at the definition of selling a Put option, you will see that in exchange for receiving a premium you are obligated to buy stock. The act of being obligated scares many investors, but if you are willing to own the stock anyway this actually decreases the risk of buying the stock outright since you are buying with a lower cost basis. Here is an example to illustrate the point:
XYZ Stock is trading at $75 per share, and an investor believes it is a good value at $70 per share but is not willing to pay $75. This investor is willing to buy the stock at $70 per share and hold it in his portfolio. He then chooses to sell the 3 month $70 Put option for $2. When the investor sells the option, the $2 goes into his account immediately. He is now obligated to purchase the stock for $70; so the capital is typically tied up. If during the course of those three months the stock does not come back down to $70 then the investor would not ever buy the stock, and the obligation would expire worthless, giving the investor a small return on the money that was invested for those three months. However, if the stock does fall at or below $70, then the investor is obligated to buy the stock at $70, but, when the $2 premium is considered, the actual cost basis of owning the stock drops to $68. This is an excellent way of acquiring stock that an investor is willing to own at a reduced risk level.
Strategy #3– Covered Calls
Once an investor owns a stock (or ETF) and has a price target to sell it, why not get paid to be a willing seller?! A common example I give when teaching a class on this topic is the example of a rental property from the perspective of a real estate investor. If a real estate investor buys a rental property for $300,000 and wants to sell it for $500,000 but the market is not yet dictating that price what can they do? The real estate investor could simply hold onto the property and let the market appreciate in value until it reaches $500,000 but would she let that property sit vacant while waiting? Absolutely not, in fact the real estate investor would probably be wise to rent out the property and collect some income while waiting for the price to reach her target. We can do something very similar in the stock and ETF market through the use of Call options. Looking at the definition above of selling Call options we see that in exchange for a premium received the investor is obligated to sell stock at a given price. While it is true that this limits the upside potential, if the investor has a price target in mind to sell the stock anyway then this can be a way that the investor would receive some additional income while waiting for price to reach her target. Here is an example to illustrate the point:
An Investor owns XYZ Stock with a cost basis of $55 per share, and it is currently trading at $65 per share. The investor is happy with her profits but feels like she is ready to cash out once the stock reaches $70. The investor could sell the 3 month $70 Call Option for $2. The $2 premium received would come into her account immediately but would now obligate her to sell the stock at $70, no matter how high the stock goes. The biggest risk to the investor is the loss of upside potential. If the stock goes to $80 the investor is still obligated to sell at $70, but if that is already the plan of the investor then it should not matter and will only serve as an extra payment. If the stock does not get to $70 in the next three months then the investor would simply keep the premium as “rental” income for being a willing seller of her stock.
These three Options strategies are all simple yet effective ways of enhancing your portfolio. To really enhance your portfolio, combining two or even all three of these strategies can be an even more effective tool. One of the things our students love best about options is the ability to combine them and truly make effective growth and income portfolios. Know your Options (as an Investor of course).