Select Options .com logo  

Do options fit in your portfolio?

Stock options are a good addition for nearly any investment portfolio that is larger than $50,000. In conjunction with a stock portfolio, options provide an efficient means to hedge, provide leverage, and/or optimize a portfolio for short-term market conditions. This occurs because stock option investments can be selected to profit in declining markets, growing markets, and especially in range bound markets.

Conservative option strategies include:

  • Selling Covered Calls
  • Selling Cash Covered Puts
  • Buying Insurance Puts
  • Buying or selling balanced Spreads

Selling Covered Calls can provide an incremental 0.5% to 1% per month (6-12% per year) on optionable stocks in your portfolio. They are ideal for holdings that are expected to grow slowly. These results are achieved by selling Calls that are 5-10% out-of-the-money that expire in 30-60 days.

Selling a Cash Covered Put is useful for participating in an "attractive stock" that has already started its upward move and has risen above its comfortable entry price. For example, an "attractive stock" has moved 5% above your comfortable entry price, so you sell a Put with a strike price 5% below the current price. The most likely scenario is for the Put option to expire out-of-the-money. Expected annualized return on risk for this type of investment should be 15 to 20%. The next most likely scenario is that the "attractive stock" temporarily dips below the strike price at option expiration date. This will result in the stock being assigned to you at an effective purchase price that is below your previously established comfortable entry price.

Puts can be purchased to protect stock in a portfolio or even the value of your company stock options. When a Put option is purchased for this reason it is called an Insurance Put. We will provide two example scenarios for Insurance Puts. Example one, a stock in your taxable portfolio has made significant gains. Now an announcement is due regarding the success of a new product line. A good report would indicate a few more years of company growth. A bad report could mean that the company has lost its edge on competitors and is likely to underperform for the next few years. Short term Insurance Put options can be purchased to protect this stock from the negative effects of a disappointing announcement. Example two, let's say you work for a company that has just had its initial public offering (IPO) and the paper value of your stock (or stock options) has become very large, but you are concerned that the stock will lose value before your lock-up (or vesting) period ends. You can purchase long term Insurance Put options to protect the value of this stock until you are able to trade it.

There are several types of balanced spread positions. Common characteristics of these positions are that both profit and risk are defined and bounded. (Spread examples are provided in other sections.) Spreads are useful in participating in stocks that you do not wish to add to your portfolio. Spreads can be designed to profit over a wide spectrum of potential stock price movements. Let's consider that over the next 60 days, the price of a stock may go higher, go lower, or stay nearly the same. If, through your research, you determine that one of these scenarios is very unlikely, then you can design a spread to profit from the two more likely scenarios and limit your loss in the least likely scenario. Spreads not only can be used on individual stocks, but they can also be used to hedge a stock portfolio. For example, let's say that the S&P500 has moved up very quickly over the last month causing broad based gains across your stock portfolio. After quick run-ups, it is common for indexes to consolidate (either a small temporary price decrease or period of stagnation) before continuing their upward trends. If you believe that the market is entering a period of consolidation, you can place a Bear Call Vertical Credit Spread on the S&P index (or index tracking ETF). Opening this type of spread helps the value of a portfolio grow through these periods of consolidation. If you are right and the consolidation occurs, the spread income becomes profit during a period when your stock portfolio value is not growing. If you are wrong, then the net effect of the spread is that you fail to realize some of the gains that occurred during your expected consolidation period. It is common that spreads with greater than 80% probability of profit can be found that yield greater than 15% annualized net return on risk.

The additional profit opportunity and risk reduction provided by options make them very attractive additions to a stock portfolio. However, investing in options profitably does require skill and the right information.

Next Section: Profitable option investing

RAF Research Link
Delayed Market Data provided by DTN Market Access.
© Copyright 2006 RAF Research. All rights reserved.        Site Use Agreement | Privacy Policy
The data and information accessible on this web site is provided "as is" and there may be delays, omissions or inaccuracies in such information and data. RAF Research, its affiliates, agents, information providers, and licensors cannot and do not guarantee the accuracy, sequence, completeness, timeliness, merchantability or fitness for a particular purpose of the information or data made available through the site. By using this site, the user agrees that the user has read, and agrees to be bound by the "Site Use Agreement".