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At this time I buy and hold stocks. In the few coming months I am considering a change in my investment strategy. If I reduce my diversification that will increase my risk. My financial coach (friend that knows about finances), suggested that I learn about options to reduce that risk and increase my possibility of returns.

At this time my yearly return is not as good as I would hope, 4-5% after cost.

What are the considerations I should ponder before integrating options into my investments?


EDIT: This question is not aimed to obtain investment advice, other than the known option investment strategies to increase gain and reduce risk of my statement above.

  • What options strategies are you considering? Options can be used for a wide variety of purposes, from relatively conservative to very risky. Is your objective to reduce downside risk? Generating income from stock positions that you currently own? Speculate on movement of a stock with smaller required initial capital (but higher risk of loss)? – Jason R Feb 12 '12 at 20:52
  • I believe that investment advices are off topic. If you are looking for information about various option-related strategies, you probably should rephrase your question. – littleadv Feb 12 '12 at 21:31
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    @littleadv - I added a few more bits of information to the question to prevent closure. – Geo Feb 12 '12 at 21:37
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I've traded covered calls now and then. This is a recent trade. Bought 1000 shares of RSH (Radio Shack) and sold 10 calls. So, I own the stock at a cost of $6.05, but have to let it go for $7.50. There's a 50c dividend in November, so the call buyer will call it away even if the stock trades below the strike. So, I'm expecting this is a 10 month trade for a 24% return.

This is one strategy where options clearly take down the risk (of course, I did not say 'remove', just lessens). The stock can be 10% lower a year out, and I'm still ahead by 8% plus the dividend if it's not canceled.

Note - it's a rare case for a one year trade to return 20% or more at a flat stock price. More common is 10-12%.

(I hope this example is acceptable as an example of this type of trade. If not, I can edit to "XYZ corp" to remove the stock name. (So if anyone comments, please do not repeat name in case I need to remove)

  • Thanks Joe! - This is good information. Let me see if I understood. 10 Months ago you bought 1,000 shares of that company for $6.05. Then you sold a Call with strike price of 7.50. Giving you the premium of the call + the 1.45 profit per share - the commission cost. Is this the right logic? – Geo Feb 13 '12 at 2:35
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    It actually looks like Joe bought the stock for $7.29, then sold covered calls against that position for $1.24 per share. This makes his effective cost basis $6.05 per share on the stock position. So, he doesn't lose any money until the stock trades below $6.05 (17% down from the price where he bought it), thus protecting him a bit against downside. However, if the stock trades above $7.50 in that time frame, then the owner of the call could force JoeTaxpayer to sell him the stock for $7.50. He would then miss out on the gains he would have otherwise had from the stock's price appreciation. – Jason R Feb 13 '12 at 2:52
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    Jason - you got it. To Geo - this just happened a few weeks back. The option I sold expires Jan '13. The Nov 50 cent dividend means I may get called early, before the ex div date. The stock can be close to $7, and still get called. – JoeTaxpayer Feb 13 '12 at 3:01
  • Thanks JasonR and @JoeTaxpayer for the explanation. To Joe - Your best case scenario is that this stock price will hover between 6.50 to 7.29 so that the sell call is not exercised. This case is an exception because they had extremely high dividends. Thanks! – Geo Feb 13 '12 at 4:35
  • Geo - without the dividend, the ideal outcome is for the stock to close at expiration at $7.49, where the buyer wouldn't bother to exercise, and I can sell a new call a year out. With the dividend, I'm just as happy to have it called in November, but believe if it trades over $7.00, the chance is that it will be called. – JoeTaxpayer Feb 13 '12 at 13:18
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It definitely depends on your risk appetite as Joe Taxpayer pointed out in his answer. Covered calls are a good choice for someone who already own's the stock, because the premium collected reduces the cost basis for the position. The downside is that if the calls are exercised, there is a good chance that you are missing out on additional upside in the stock price (because the strike is obviously below the market value for the stocks).

Another good option trade is the spread option. This would allow you to capture the difference between the two strikes of the options in the spread. This is also one of the less risky choices because your initial cost an potential profit/loss are known in advance of entering the position.

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    +1 Agreed. Early on in the dotcom bubble, I caught a stock trading at $50. One year out, the difference between the $80 call and $90 call was only $1.50. Both calls seemed highly priced, but that was irrelevant when buying the spread. The stock (remember, bubble) peaked at $160, before crashing. It traded at $120 when my spread expired. $1500 turned to $10000, minus 4 pretty small commissions. When the bubble burst, of course, any option positions I had were worthless, as I had no puts. But I never had all my money in the game. – JoeTaxpayer Feb 13 '12 at 13:29
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I think you need to be very careful here. Covered calls don't reduce risk or increase performance overall. If they did, every investment manager would be using them. In a typical portfolio, over the long term, the gains you give up when your stock goes beyond the strike of your calls will negate the premiums you receive over time. Psychologically, covered calls are appealing because your gains happen over a long period and this is why many people suggest it. But if you believe the Black-Scholes model (used for pricing options) this is what the model predicts over the long term - that you won't do any better than just holding stock (unless you have some edge other traders don't).

Now you say you want to reduce diversification and raise your risk. Keeping in mind that there is no free lunch, there are several ways to reduce your risk but they all come at a price. For simplicity, there are three elements to consider - risk, potential gain and cash. These are tradeoffs and you can't simultaneously make them all favorable. You must trade one or more of them to gain in the others. Let's say you wanted to concentrate into a few stocks... how could you counteract the additional risk?

1) Covered calls: very popular strategy usually intended (erroneously) for increasing returns. You get the bonus of cash along with marginally less risk. But you give up a substantial amount of potential return. You won't have blowout returns if you do this. You still face substantial risk.

2) Collar your stock: You sell a covered call while using the cash from the sale to buy puts for protection. You give up potential gains, you're neutral on cash but gain significantly on reducing risk.

3) Use calls as proxy for stock: You don't hold stock but only calls in equivalent delta to the stock you would have held. Substantially lower risk while still having potential gain. Your tradeoff is the cash you have to pay for the calls. When using this, one must be very, very careful not to overleverage.

4) Puts as protection for stocks: This is basically the same as #3 in tradeoffs. You won't overleverage and you also get dividends. But for the most part it's the same.

These are the main ways to reduce the risk you gain by concentrating. Options themselves are far broader. But keep in mind that there is no free money. All these techniques involve tradeoffs that you have to be aware of.

  • I guess I have to quibble with the doesn't reduce your risks statement. If the alternative is to simply own the stock then at a minimum by selling the call you've gained the premium for selling the call. So that is a risk reduction already. You've locked in the most you can lose, which is better than it was without selling the calls. Also, as far as long term gains not being much different, I guess it depends on how good of a stock picker you are. If you are good then your statement is probably true. However, for those who aren't so good, locking in 10-15% returns a year is pretty solid. – Dunk Feb 14 '12 at 20:34
  • @Dunk, you are right if you're looking at one stock in isolation. But when looking at a portfolio of several stocks over time, the better performing stocks make up for the poorer performing ones. By limiting your better performers you effectively negate the reduced risk on the worse performers. – robotcookies Feb 14 '12 at 21:16
  • I admit, you lost me. You seem to agree the single stock risk is taken down a bit, but a group of them less so. In my example below, I've lowered my cost by 20% from current market, and a relatively flat return over the next year with return 25%. Maximum, of course. The stock doubles, and I'm still up only 25%. A dozen positions with this profit/loss curve seems desirable to me. – JoeTaxpayer Feb 15 '12 at 3:38
  • @Joe, radio shack is a company that recently dropped 30% in a single day. Could it drop 25% over the next year? Sure. There's a fairly good chance of that. It might not, it could do very well over the next year. But what I'm saying is that if you did this with say 40 stocks very similar to RSH, a significant portion of them would drop more than what your option covers. Now some will do very well but you don't benefit from that. To be con't. – robotcookies Feb 15 '12 at 6:22
  • The real question is how would your strategy using cc compare with someone who buys distressed stocks without cc (some of whom do very well) over the long term, assuming no edge. The Black-Scholes model says the two would do fairly similar. Now there are critiques of the BS model and they say that in fact, the call seller will do worse and this is ignoring commissions. But that's beyond the scope of the discussion here. The pricing model itself claims this performance between the two. If you use CC it should be based on a belief that the stock will stabilize in price-not as a blanket strategy. – robotcookies Feb 15 '12 at 6:38

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