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
|
