Can options work in a conservative way and actually help protect your portfolio?
Most conservative investors traditionally have seen options as high-risk, speculative plays on short-term market swings. This is appropriate when you think of the many high-risk option strategies available. But increasingly, options are going mainstream as even the most risk-averse investors find ways to use options to lower risks while protecting their long stock positions.
Three basic ways this is accomplished:
1. Covered call writing. The covered call has two parts: Ownership of 100 shares of stock, offset by the sale of a call. When you sell, you grant someone else the right (but not the obligation) to buy your 100 shares at a fixed strike price, on or before a specific expiration date. You keep the cash you get for selling the call and all dividends you earn before exercise. If exercise doesn't happen, you still own your shares and after expiration of the short call, you can repeat the strategy. Two important qualifications: You must be willing to give up your 100 shares at the strike price (which should be higher than your basis in the stock), and you must also be willing to give up any appreciation above the strike if and when the stock's price takes off.
2. Long puts for insurance. Let's say you bought stock you want to keep for the long haul and its value has soared very high and very quickly. You expect some degree of reversal because prices went up so quickly. So you're tempted to sell and take profits while you have them; but you still want to hold onto the stock for the long term. The alternative is to buy one put for each 100 shares. If the stock price declines, the put's intrinsic value will rise for each point you lose in the stock. This eliminates your downside risk for the period the put is alive, and the premium you pay for the put is the cost of protection, the insurance you gain with this strategy.
This strategy can be combined with the covered call to set up a collar, with both call and put out of the money. The advantage here is zero cost. The short call pays for the long put, and you benefit from exercise or expiration of the call while also getting downside protection from the put. This variation should be used only when stock has appreciated above your basis, so that all outcomes will be favorable. Another variation is the synthetic stock, a combination of a long put and a short call at the same strike. If the stock's value falls, the long put offsets the loss; if it rises, the short call will be exercised or can be closed or rolled forward.
3. Long LEAPS calls for contingent purchase. A LEAPS is a long-term option. The acronym stands for "Long-term Equity AnticiPation Securities," a fancy name for options that may exist as far out as 30 months. So if you like a company's stock today but you can't afford to buy 100 shares, investing in a LEAPS call is one choice. This creates a type of "contingent purchase." You control 100 shares but your risk is limited to the cost of the LEAPS call. You can exercise it any time you want before expiration. So months later when you have the cash but the stock's price has risen well above the strike, exercising the call fixes your price no matter how high it has moved since then, for much less money than it would have cost to buy shares.
The LEAPS put can also be used for contingent sales. This is most valuable when you own appreciated stock and you want to protect paper profits. If the stock price falls, the long put can be closed at a profit to offset the loss, or exercised to take profits.
In both cases of call and put LEAPS, the cost of the contract has to be considered to justify the strategy. Because these are long-term options, time value will be considerable; so the LEAPS is not a risk-free strategy, but it does serve a defensive purpose in many circumstances.
There are many additional ways options can be used to conservatively protect portfolio positions and also to increase cash profits. The point is, options are not only for the high-risk strategy and they no longer are used only by speculators. Investors can also put options to work in conservative strategies.
If a strategy includes the use of short uncovered options, collateral requirements also have to be considered. To check on the rules for short option collateral, download the free report from the CBOE at CBOE Margin Manual.
As part of evaluating options, you may also want to compare volatility and probability. The CBOE also provides a valuable options calculator to help define these attributes. To use the free calculator, go to CBOE Options Calculator
Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. See the Thomsett Publishing Website In addition, he also publishes widely on the topic of candlestick charting. You can discover the world of effective chart reading with Profitable Trading Strategies Using Candlestick Charting. This is a comprehensive and complete course on the nature of candlestick charting, offered exclusively by the Global Risk Management Community. By the conclusion of this course, you should be able to locate actionable candlestick signals, better understand what is likely to occur next, and combine candlesticks with other technical signals to forecast price movement. To find out more, go to Using Candlestick Charting
Comments