In my last article I discussed the basics of using options. The two scenarios I outlined are common uses of options, but they aren’t how I’ll be using them in our conservative stock portfolio.
The first strategy I plan to use immediately involves selling call options on stocks in the portfolio (yes, you can sell options you don’t own; it’s called “writing an option”). What I’m doing is selling someone the option to purchase 100 shares of a stock I own at a certain price (the strike price) on a certain date (the expiration date). This strategy is called Writing Covered Call Options. It’s “covered” because I own the stock I wrote the option on. If I don’t own the stock, it’s called Writing Naked Call Options. Naked options are much riskier, in general, than covered options, and I won’t be discussing their use.
Here’s the scenario: I have purchased 100 shares of Company XYZ for the portfolio, and it’s currently at $36 per share. A call option on XYZ with a strike price of $40 that expires in 90 days is priced at $0.31. I sell the option on my 100 shares and receive $31. Regardless of what the price of XYZ is in 90 days, I keep the $31. If the price of XYZ rises to $40 or higher, my stock gets sold and I receive $4,000 for it (the strike price). If it doesn’t reach $40, I keep the stock and the $31. That $31 of income in 90 days on my $3,600 stock investment is a yield of approximately 3.5% annually. Not bad, considering the only risk I took was that my stock might be sold and I would miss out on potential profit above the selling price of $40 per share. But had the stock sold I would have received $400 of profit ($40 selling price minus the price of $36 when I sold the option), or 45% on an annual basis! That is in addition to any dividend XYZ would pay out while I owned the stock.
Now let’s say the option I sold on XYZ was executed and my shares were sold at $40. I now have $4,031, less commissions, to reinvest in XYZ or another company. Let me introduce you to my second option strategy: selling cash-covered puts. Selling a put gives the buyer the option of selling a stock to me at the option strike price on the expiration date if the stock is selling at or below the strike price. In essence, I’m collecting cash while waiting for a stock to drop in price to what I wish to pay for it. If it doesn’t drop to the strike price or below, I’m not obligated to buy it.
So, after selling the XYZ stock, I decide to buy ABC Company stock. Its current price is $43 per share, but I don’t want to pay more than $40 per share. As long as I have the $4,000 in my account to cover the cost of purchasing 100 shares, I can sell a put with a strike price of $40. If the stock drops to $40 or below, I would exercise the option and purchase the stock at $40. A put option with a strike price of $40 that expires in 60 days is available for ABC Company for $0.65, so I sell one and pocket $65. My annualized return on an investment of $4,000 (the amount I must have in my account to purchase the stock) over the 60 days is, get this, 9.75%! Where can you earn that kind of return on cash sitting idle these days? I keep the $65 whether I end up purchasing the stock or not.
The risks involved with selling puts in this manner are two-fold. If the strike price isn’t reached and the stock isn’t purchased, it could go higher before I get the chance to purchase it and miss out on potential gains. Or, the stock price could plummet well below the option strike price, but I would still be required to pay the strike price for the stock and be in the hole from the time of purchase. However, considering the conservative nature of the stocks I intend to use in this portfolio, rapid movements of this kind are not very likely. The reward, in my opinion, far outweighs the risk.
I realize this has been a long post to read. If you’ve reached this point, congratulations! You now know more about options investing than most investors. The two strategies I’ve just discussed work well with a conservatively designed stock portfolio, and can result in very nice returns for the long-term investor in a market that’s moving up or sideways. In my next post, I’ll reveal the makeup of the two portfolios I’ll be tracking, one consisting of conservative stocks and options, and the other comprised entirely of precious metals. Let the games begin!