To many investors, options are scary things. They are, after all, a “derivative” and employ “leverage”, two things that most people have (probably quite rightly) been told to be wary of. The image of options often isn’t helped by those that do trade them. I remember an excruciating couple of hours in a London pub one time when I had asked a guy on our options desk to explain them to me. He hit me with more Greek than you would find on a college campus, and some MIT-like equations to help the poor, dumb currency guy understand just how complicated options were. I left more confused than when I started, and with the impression that options were a geeks market that existed mainly to allow smart people to impress on people like me just how smart they really were.
It took a while before I became comfortable with the product and I now regard at least a working knowledge of options as indispensible for traders of any stripe. If you are a trader and have never used options before, please don’t just jump in and start trading. They do employ leverage and can be dangerous to your wealth if you don’t understand the market. Most of what you need to know is available online or, better still, there are some great courses available.
The utility of options for traders is fairly well-recognized, but when it comes to investors there is less agreement. As a financial advisor, I had colleagues in both camps; those that believed they were a valuable tool for their clients and those that believed they shouldn’t be touched with a ten-foot pole. I am inclined towards the former position, but with limits. There are two basic strategies that I believe are useful to investors, beyond that options are best left to the pros and day traders. Before we get into them, let’s look at the basics: what options are and how they are quoted.
An option on a stock is just that, an option to buy or sell at a pre-determined price at some point in the future. Options are traded in contracts, with each contract representing 100 shares. The price, however, is quoted per share. Thus if the price quoted is $0.50, the cost of one contract would be $50.00. There are two basic types of options: an option to sell in the future, termed a “put”, and an option to buy, known as a “call”. There are various time periods available; how many depends on the liquidity of the stock. For the purposes of the two strategies that we will discuss, though, those in the 3-6 month range would be the focus. The “strike price” is the price at which you have the option to buy or sell at expiration (the end date of the option). For example, if you buy an October 19th 400 put on AAPL, you have the option to sell AAPL stock at $400, regardless of the market price, at any time up until October 19th.
Okay, now we know what they are, let’s take a look at the two ways I believe options can be of use to even the most conservative of investors.
Covered Calls: A covered call is a way of generating income from a stock that you don’t believe is going to be roaring up anytime soon. Let’s say you own shares in General Electric (GE). You may feel that the reaction to the recent good earnings was a little overdone and, while you don’t really want to sell at these levels, you would like a way to take advantage of that.
You could sell October 25 calls for around $0.66 per share, based on yesterday’s close. Remember, this means that you are giving somebody else the right to buy your GE shares at $25.00 anytime until October 19th. The break-even point for both of you however, must include the money paid, or “premium”. The buyer of those calls would not exercise that option unless the price exceeded $25.66, or they would be locking in a loss. If that price is never reached, you get to keep the $0.66 per share, or around 2.6%.
This can be a useful way of generating additional income, particularly if you have a large portion of your holdings in one stock and don’t mind the prospect of selling some in the near future.
Protective Puts: A protective put is a way of “insuring” your holdings in a particular stock against a drop in price. Like all insurance, it costs you money that you only recover should things go wrong. The idea is simple. This time, you would be the buyer, buying the right to sell stock that you own at a fixed price at any time during a pre-set period.
Using the GE example above, you could buy October 24 puts for around $0.63 per share, giving you the option of selling at $24.00 any time up to expiration. Again the premium must be taken into account, so your real break-even point is the $24 selling price less the $0.63 it has cost you to buy the option, or $23.37. Should the market, or just GE stock, collapse in the next three months you can sell your shares at a net price of $23.37 at any time.
It is possible to do both of these things at the same time, resulting in a zero, or low cost collar. At these levels it would cost a small amount in commissions, but would give you protection against a drop. What you trade for that protection is the possibility that, should the stock go up, you may have to sell below the market.
The point is that options don’t have to be scary. If you wanted to do either of these things, you would have to be approved for options on your account, which involves some paperwork, but that shouldn’t be too much of a problem. Conquering any fear you may have, and ditching the “it’s all Greek to me” attitude may be more troublesome.