Sample Option Strategies

Option strategies provide investors with an intelligent method for reducing the risk associated with investing. Options also provide the more aggressive investor with a method for achieving outstanding returns, albeit those higher returns do not come without added risk. Because options are versatile investment tools, a variety of strategies is available. Most are very easy to understand, and there is no need for the average investor to be concerned with complex strategies. A few examples follow.

Buy Puts to Insure a Long Stock Position
(Also Called Protective, or Married, Puts)

When buying put options, the investor gets to own the most complete insurance policy—one that guarantees the ability to sell his/her stocks at pre-arranged prices. The higher that guaranteed price, the more expensive the put option. Think about buying an insurance policy with a deductible. When the deductible is smaller, the policy costs more. Puts work the same way. If you choose a higher guaranteed sale price (smaller deductible), then the cost of the put (the premium) is higher.

One characteristic of options that makes them unique in the investment world is that options have a limited lifetime and expire on a known future date. Options are available with a variety of lifetimes: short (weeks) or longer (more than two years). In addition, options are “wasting assets” and slowly lose value as time passes. When expiration arrives, the put owner (remember, it is being used as an insurance policy) may “exercise the option” and sell stock at that predetermined price. The alternative is to sell the option (if it has any remaining value) or allow it to expire (just as our other insurance policies expire and must be renewed annually).

The price guarantee is valid for a limited time (until the option expires). During the lifetime of the option, the investor can rest assured that no matter how low the stock price may decline, he/she can sell those shares at that pre-arranged price. That means that all losses are capped, or limited. This idea of being able to insure the value of a stock market portfolio is something that should be far better understood by individual investors. However, for whatever reasons, that is not the case. There is something about “options” that prevents the financial press from alerting their readers or listeners to how options can be used intelligently. The major purpose of this piece is to make readers aware of the important ways that options can be used by “mom and pop” investors. Protecting assets is at the top of that list.

How easy is it to understand how put options function? If you know that an automobile insurance policy allows you to sell the car back to the insurance company when it is “totaled” or destroyed, then you understand how owning a put option allows you to sell the insured item (100 shares of a specific stock) to someone else (an unknown investor who sold the put option) at an agreed-upon price (the option’s strike price). And there’s more good news. You don’t have to be concerned with the viability of the insurance company (person who sold the option). Your right to sell those shares is guaranteed by the OCC (Options Clearing Corporation).

The drawback to owning put options is they tend to be expensive, and some investors would do better with an alternative type of protection.

It is important to mention: This is an option. You are not obligated to sell your shares. When expiration day arrives, you may sell your shares at the strike price, or you may keep them. The choice, or option, belongs to the person who bought the insurance policy (put option).

Sell Calls When You Own Stock
(Covered Call Writing)

Another common choice is to “write covered calls.” This plan offers far less protection against loss, but the compensating factor is that it does not cost any cash out of pocket. In fact, you, the shareholder, are paid by someone else who wants to buy the call options that you are selling. This insurance is far less powerful than buying put options. Protection against loss is limited to the cash collected when selling the calls.

It’s quite a choice: Pay more cash and own complete protection. Or collect cash and have far less protection. We don’t have such choices when dealing with a regular insurance company. We may insure our cars, possessions, houses, and lives against loss, but we cannot arrange to be paid for owning less insurance.

Here’s an example of how writing covered calls works. John collects $5 per share and, in return, becomes obligated to sell his shares at the known (strike) price at any time before the option expires. John uses that cash ($500 per 100 shares) generated by selling call options as protection against loss—as long as the stock does not decline by more than that $5 per share. Although this plan offers limited protection, John has $500 that the buy and hold investor does not have.

The provider of insurance (Mary, the buyer of the option) can hedge her risk or speculate by holding the option. Although it is beyond this discussion, by speculating, Mary can earn a significant profit when the stock rallies well above the strike price. Why? Because Mary has the right to buy shares at the strike price, no matter how much higher it may be trading on the stock exchange.

When John sells those call options, he is giving the option buyer the right to buy his shares at a predetermined price—for a limited time. That’s another type of risk. John could be forced to sell his shares at that pre-arranged price and could miss out on a substantial rally. In effect, John traded potential profits for that $5 per share payment.

Collars

The versatility of options trading is demonstrated by the collar strategy which gives the investor the same protection as owning puts, but at a far lower cost. The idea is to buy a protective put and to write (sell) a covered call at the same time.

The cash collected when selling the call is often sufficient to pay the entire cost of owning the put, but that depends on the details of the trade. For example, if John owns 100 shares of a stock trading near $150 per share, he may decide to buy a put with a 140 strike price. (Translation: Until the option expires, John has the right to sell 100 shares of this specific stock and collect $14,000—that’s 100 shares at $140 per share.).. John may also decide to sell a call option with a strike price of $155 per share. That would give the call buyer (perhaps Mary) the right to purchase his 100 shares by paying $150 per share—at any time before the option expires.

By choosing identical expiration dates for the put and call options, the entire process is simplified. When the options expire, John will either sell his shares at $140 (if the stock price is lower) or $155 (if the stock price is higher), or keep his shares when the stock is priced between $140 and $155.

If he paid more for the puts than he collected for the calls, then the difference represents the cost of owning insurance against a disaster. If John collected a higher premium when selling the calls than when buying the puts (as he likely did using the prices in the example), then John still owns protection against a big loss, but this time he collects net cash. That cash is his to keep, no matter what else happens.

This is an example of owning insurance at no cash out-of-pocket cost. The “only” cost is the possible forfeiture of future profits. If the stock moves well above that $155 selling price, John is obligated to sell his shares at the strike price of the call options, or $155.

Stock Replacement with Call Options

Most options rookies who attempt to make money by buying call or put options make mistakes by owning the wrong options. Yet, the intelligent, conservative investor who wants to own stocks and be protected against big losses can adopt a neat strategy.

Although this idea is viable at any time, investors who already earned significant profits from their holdings in individual stocks often find this play to be especially attractive. It can be psychologically satisfying to lock in profits and remain in position to earn even more money if and when the stocks continue to increase in value.

The downside is the necessity to pay a capital gains tax on the profits. In my opinion, avoiding risk is far more important to an investor’s long-term success than being concerned with taxes. Not everyone agrees, and thus, this specific idea is not for every investor.

Example: Mary owns 300 shares of XYZ Corporation. The stock price has appreciated, and now that it is trading at $87 per share, Mary recognizes that there is considerable downside risk. Being a savvy investor/trader, Mary decides to sell her shares, taking $26,100 off the table. However, she still believes in the future of this company and wants to prosper if the stock continues to do well.

Mary can accomplish the twin objectives of remaining invested and cutting the amount of cash at risk by replacing her 300 shares with three XYZ Jun (or any expiration month) 80 calls. These call options come with a strike price of 80. That means Mary can buy 300 shares of stock at $80 per share at any time prior to the option expiration date (six months in the future for this example). Mary pays $800 per option ($8 per share) for the calls. Owning calls that cost $800 limits her loss to that $800, regardless of how low the price of XYZ shares tumble. (If you recall, buying put options offers a similar guarantee.)

There are two major points to mention:

• Mary has the protection that she needs because her maximum loss is 3 times $800, far less than she could lose when owning 300 shares of stock.

• This six-month insurance policy cost $300 or $1 per share. How is that number calculated?

• Mary sold her stock at $87.

• Mary now has the right to buy stock at $80. However, she also paid $8 for the call options. Thus, if Mary decides to convert her options to stock, that stock will cost a total of $88 per share. That’s $1 more per share for 300 shares or $300.

If that seems to be a complete waste of $300, consider what happens if the company issues bad news and the share price declines to $65 per share. If Mary had continued to own the shares, she would have lost $22 per share or $6,600. Because her options were worth only $2,400, her loss cannot exceed that sum. The further the stock declines, the more cash Mary saves. And if the stock never declines? If it continues to trade in the high 80s or above? Then Mary will “lose” that $300 she paid for insurance. For many investors, that’s a very inexpensive cost for the secure feeling that comes with any insurance policy.

There’s more good news. Because Mary collected $26,100 and reinvested only $2,400, the remaining cash can be put to work earning interest. Any interest earned reduces the cost of owning insurance.

Each investor must decide if the insurance policy is worth owning, but it is the versatility of options that makes this choice possible.

Being unaware that you can obtain this protection for your investment portfolio is not acceptable. One major purpose of this piece is to be certain that each reader understands his/her investment-protection alternatives. The brokerage industry does not make a sufficient effort to alert its customers to the idea of using options as a means for protecting assets.

Speculation

I prefer to refrain from discussing the speculative use of options because it is very difficult for the average investor to make money when speculating. However, there is no denying that this is a popular choice among option traders—especially novices.

Options allow the investor to use leverage. That means a small amount of money can be used to control far more dollars worth of stock. If the speculator has a good sense of timing and correctly predicts market direction, he/she can turn that small sum into something many times as large. That’s the attraction. It’s not that different from buying a lottery ticket (with a smaller payout).

The bottom line is that beginners quickly learn how to gamble with options. What they don’t learn (until it is too late) is that the chances of winning are very small. For those with a get-rich-quick mentality, this is an attractive use of options. Anyone who takes the time to understand exactly what must come to pass before one of these speculative plays can earn a substantial profit knows that the most likely result is the loss of the entire cost of playing the game. It is human nature not to be concerned with risk. Instead, these beginners place their bets, lose their money, and then begin to ask questions. If you insist on using options for speculation, it is to your advantage to understand how options work so that you can have an improved chance of a profitable trade.

I encourage readers to avoid taking big risk when using options. Options were designed as hedging tools, and that means they were designed to reduce the risk of owning any investment. As a bonus, some strategies increase the investor’s probability of earning a profit, although that profit is often limited. For the investor with a longer term investment horizon, less risk and more frequent profits represent a very desirable pair of characteristics.