Options are one of several tools you can use to (a) optimize profits and (b) minimize and hedge risks in your portfolio. But you need to know specifically which options strategies are going to achieve this desirable two-part goal.
- Covered calls
The covered call is a popular and widely understood strategy. You own 100 shares and you sell one call. As long as you accept the downside risk of the stock (which you have whether you write covered calls or not), this is a smart and profitable idea. But the first step should be to make sure you pick stocks wisely, using smart fundamentals to ensure low market risk and strong financial trends. Also make sure you pick a strike that, if exercised, will produce profits in the stock. If you write covered calls slightly in the money with about one month to expire, you are going to generate annualized double-digit returns consistently. It’s more profitable to write one-month calls every month than to write a one-year call once per year. Check the options listings and you will see that although you get less cash for the short-term options, it works out to more on an annualized basis, because time decay is accelerated in the last month.
- Uncovered puts
In considering the risk/reward scenario of covered calls, also think about the uncovered put. Often considered high-risk, the actual market risk of uncovered puts is the same as risks for covered calls. Among the pro and con is the flexibility to roll out of the put without regard to the stock price. With a covered call, a roll has to be made in consideration of the basis in stock, so that exercise will not create a net capital loss. With the uncovered put, it does not matter which strike you roll to as long as you avoid exercise. Early exercise is not impossible, but it will not occur as long as the put remains out of the money (when the stock price is higher than the put’s strike). The uncovered put strategy benefits from time decay. The short position loses value as expiration approaches, and the put can be bought to open at a profit as long as the stock has not moved below the put’s strike. You are required to put up approximately 20% collateral for this and any other uncovered short position, but this remains a desirably leveraged strategy. To calculate how much margin has to be put up, go to the free CBOE margin calculator: http://www.cboe.com/trading-tools/calculators/margin-calculator
- Ratio writes
Think beyond the covered call as well. A ratio write is a covered call with partial covered and partial uncovered sides. For example, if you own 300 shares and you sell four calls, you create a 4:3 ratio write. You can think of this as four calls with 75% cover, or as a combination of three covered calls and one uncovered call. As long as time decay outpaces any growth in future intrinsic value, this is a profitable strategy. Pick strikes out of the money and then track carefully to make sure you don’t get exercised. Also watch out for any ex-dividend dates that arise before expiration. If your ratio write positions are in the money at ex-dividend date, exercise is a strong possibility. If these positions go in the money, you can close (hopefully at a profit), roll forward, or accept exercise. You will need to provide collateral based on the uncovered portion of the position.
- Variable ratio writes
The ratio write can be made safer with a variable ratio write. This is the same strategy as the one-strike ratio write, but using two strikes. For example, if you bought 300 shares at $37 and the stock is now at $39, a 4:3 variable ratio write could consist of two 40 calls and two 42.50 calls. Using expiration within one month will maximize time decay, reducing market risks effectively for OTM positions. If the stock begins moving up, either of the strikes can be closed or rolled. But having the cushion between the two strikes makes it easier to avoid exercise and to end up with positions you can “buy to close” at a profit.
- Synthetic stock
A defensive position is justified at times as well. For example, if you are bullish on appreciated stock, but also concerned about the possibility of a downside correction, consider some advanced options ideas. This is especially worthwhile for high-yielding stocks when you want to hold on to your positions at least through ex-dividend date. These positions include synthetic short stock (a long put and a short call).
In this defensive position, if the stock price rises, the short call is at risk of exercise. If the stock price declines below the put’s strike, you can sell the put at a profit.
Synthetic long stock is an opposite strategy, involving a long call and a short put. This is the equivalent of a long call and a covered call, since the short put’s market risk is equivalent to the covered call risk. If the market value of the underlying rises, the long call appreciates and can be sold at a profit; if the market value falls, the short put is at exercise risk and should be closed or rolled forward.
There are many more ways to use options for portfolio management. The point to remember is that more and more, conservative investor as are using options to reduce or eliminate portfolio risks, and that is just smart investment risk management. The older perception of options as reckless high-risk gambles still applies if options are used speculatively, but conservative investors now can play the game as well.