Options Provide Benefits

By: Joe Duffy and Darrell Jobman

The following is an excerpt from Joe Duffy and Darrell Jobman's Inside Secrets of the Mile-High Cash Club

Protection & Insurance

Aside from speculative possibilities, options have some very practical applications in an investment portfolio, especially in protecting the value of assets.  In fact, some traders keep options in place instead of stops to protect their positions, and some use options on a spot basis for temporary protection when potentially dramatic price changes could occur, such as through the period of a government report, a meeting of the Federal Open Market Committee, etc.

Assume that you have accumulated a nice assortment of stocks that you would like to keep in your portfolio for the long haul.  However, the investment climate is changing, and you are worried that the value of your stocks could decline significantly.  To protect against a price slide of something that you own, you could buy put options – in this case, on the stocks themselves or on a stock index or stock index futures contract that is most closely aligned with your portfolio.  If the price of the stocks does decline, the put will increase in value to offset at least some of your loss in the underlying stocks.  And your portfolio is still intact.

Or assume you are the producer of a commodity and prices are relatively low.  Rather than take on the risks of storage and waiting for a price rebound that may never come, you decide to sell in the cash market.  However, to profit from a price rally if one should develop, you could buy calls.  If prices do pick up, the value of the call should increase, offsetting at least some of the sting that you might feel because you sold too soon and letting you participate in the price improvement.

If you do decide to use options for protection, the key question is: What do you want to set as your “deductible”?  When you buy car insurance, the more coverage you want, the more you pay.  If you want $1,000 deductible – that is, you assume the liability for the first $1,000 in damages and the insurance company pays the rest – you pay less than you would have to pay for a $300 deductible policy, all other factors being equal.

The same concept applies to options.  If the price of the underlying instrument is $100, do you want “coverage” to begin at $100? $90? $80?  The lower the strike price of the put option you buy, the lower the premium.  How much coverage can you afford?  If prices do not drop, you could lose all of the premium so the more you pay, the more you might lose.  On the other hand, if the strike price is too low, it may not provide enough coverage and loss of the premium is almost a sure thing.  It’s like putting your car insurance deductible at $10,000 so it covers only the worst of disasters.

Incremental Income

Now here is where an options seller has an edge over the buyer.  As a wasting asset, options decline in value at a rate that increases as expiration approaches, a factor that can work against an option buyer waiting for something to happen to help his/her position during the time that the option still has life.  But, a wasting asset is just what the seller wants because it reduces the time of vulnerability to a potentially unfavorable move.

One of the favorite tactics that investors use to get additional income from underlying instruments they hold is the “covered call.”  Speculators who do not own the underlying instrument may sell “naked calls”, although that is a somewhat riskier proposition that requires much more careful management.  When the underlying market has gotten stagnant or volatility begins to slow down, or it doesn’t appear likely to reach a specific strike price, traders can sell a call option and collect the premium.  The money goes into your account immediately.  If the underlying price does not reach the strike price by expiration, you keep it – and perhaps repeat the process.

Assume you buy a stock at 50 and the price advances into the 60s where the market seems to stall out.  You would like to continue getting returns from your position so you sell a 70 call for 4.  If the market does not reach 70 by the expiration date, you pocket $400 for your account.  You may be able to do that several times, each time collecting the premium and, in effect, lowering the price you paid for the underlying instrument.

But, let’s say that, surprise of surprises, the market suddenly spurts above 75, and the call option buyer decides to exercise his/her right to have a long position at 70.  You are obligated to provide your shares at 70.  On the one hand, it looks like you will miss out on the bull market, perhaps the reason you bought the underlying stock in the first place.  On the other hand, when you sell the underlying asset, you have the gain from 50 to 70 plus whatever premium you received, so you have done quite well with this position and can move on to the next investment.

Depending on your motives, the decision on the strike price can be quite important – too close to the market and you are likely to lose your stock that you may want to keep, too far from the market and you may not find the premiums worthwhile to cover the risk and cost.

Positioning

This is somewhat like the other side of the coin of the aforementioned where you sold a covered call to get additional income because you did not expect prices of the underlying instrument to reach the call strike price.  In this situation, you are looking at the other end of the price scale, low price levels, and do not think prices can get much lower so you sell a naked put option.  If the market does not slide below your strike price, you collect the premium.

You could also use this strategy to buy the underlying instrument at a lower price than the current price.  Assume the price of the underlying instrument is at 50, and your analysis suggests it is unlikely to go below 40.  You sell a 40 put option for a premium of 3 – not a big number but it looks like an investment without a lot of risk.  You can win two ways – either collect the premium if the market stays above 40 or buy the underlying instrument at a very favorable net price of 37 (40 strike price minus 3 that you received as the premium).  This is a bargain that you had not expected.

However, before you jump into this “sure-thing” strategy, several caveats should be mentioned.  First, if you should get assigned the position in the underlying instrument, you must have the money to purchase it in your account.  That could be a sizable amount, if you have given into the temptation to sell multiple puts to make up for the relatively low price for each.  Second, an underlying instrument that has dropped so far that “it couldn’t possibly go any lower” sometimes does go considerably lower and you wind up holding a very expensive and overpriced instrument.

There are several notable examples of times when a put selling strategy backfired, including the October 1987 stock market crash, so it is not a position to take lightly, even when all the odds seem to be in your favor.

Multiple Choices

If you become familiar with the techniques to trade options, you have plenty of places to use your skills.  A market that you know probably has an options contract available because there are options on so many different financial instruments over many time frames, from very short-term options to the long-dated stock market LEAPS that go out two or three years.  Popular stocks may have both call and put options at 20 or 30 strike prices in three or four different months – perhaps several hundred options for just one stock.  So, you have no lack of options from which to choose for almost any strategy you like.