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You’ve probably heard people refer to options as a risky venture, similar to gambling. And it is true that options trading can be very risky, especially when done with minimal knowledge and preparation. The average stockbroker or financial planner does not have enough knowledge of options to guide you in using options in your portfolio. But that doesn’t mean options can’t play a role in a conservative stock portfolio.
Most of today’s options trading volume is derived from institutional money managers who use options to protect their clients’ stock portfolios. They are using options like insurance. Options can also be used to increase the income that can be derived from a conservative stock portfolio.
Written stock options are called stock options and they come in two forms: calls and puts. A call option gives the option holder the right to buy the underlying stock at the option’s strike price at any time before expiration. A purchase option is similar to a supermarket coupon for a five-pound bag of flour at an attractive price; but the coupon is only valid for 30 days and is limited to the purchase of a five-pound bag. Similarly, a call option gives you the right to buy 100 shares at a specific price and is only valid for a certain period of time.
Put options are opposite in nature to call options and are more like insurance; A put option gives the owner the right to sell the underlying stock at the option’s strike price at any time before expiration. Put options are often bought when one expects a stock price to decline, or could be used as a form of insurance if I already own the stock; if my share price declines, my put option appreciates and offsets some or all of that loss. An excellent analogy is home insurance; If I pay my insurance premium on January 1 and nothing happens to damage my home this year, my insurance becomes worthless, just like my put option will become worthless if my stock continues to appreciate. But if a hurricane damages my home during the year, my insurance pays for some or all of the repairs. Similarly, if my stock price declines, my put option will increase in value, replacing some or all of the loss in my portfolio.
Stock options expire on the Saturday following the third Friday of each month. It is common to hear or read that stock options expire on that third Friday. While that is not technically correct, it is true that Friday is the last chance to trade those options. The Saturday expiration was set to give the Options Clearing Corporation and brokerage houses time to settle their clients’ accounts before the options technically (legally) lose their value.
Consider the hypothetical company, XYZ, as an example. XYZ closed on May 28, 2009 at $34.70; the $35 June call option was trading at $1.00 at close. In option quotes on a site like Yahoo Finance, you’ll see bid and ask prices posted. The Ask price is the price quoted if I want to buy the option, while the Bid price is the price I would have to pay to sell my option. Options are priced per share of the underlying stock, but are sold as contracts covering 100 lots of shares. The $35 June XYZ calls are trading at a ask price of $1.00. Each contract is priced at $1.00 per share of the underlying stock; Since each contract covers 100 shares, one contract costs $100 and five contracts would cost $500. I have the right to exercise my options at any time before they stop trading on Friday, June 19, and purchase 500 shares of XYZ at $35 per share or $10,500. Or I could just sell my call options at the offer price at any time before expiration.
Options can be used in a number of very conservative ways in a stock portfolio. For example, if I own 300 shares of XYZ, but am concerned that this market is weakening and may drop again, I might buy three contracts of the $35 June Put Options at $1.40 to protect my position. This short position would cost me $420 and protect me until June 19th. As XYZ falls in price, the put options will increase in price, offsetting some or all of my loss on the stock. This is called a “married sale” position. However, there is no free lunch at the market; if XYZ trades sideways or up, I will lose my $420 “insurance premium”.
Another conservative use of options is the “covered call” strategy. If we continue with our XYZ example and I think the stock will trade sideways or slightly higher over the next few weeks, I could sell three contracts of the $35 June calls for $1.00, which would bring $300 into my account. If XYZ trades flat at $34.70 on June 19, the $35 call options will expire worthless and I will have earned $300 or 2.9%. But if XYZ trades above $35, my maximum profit is capped at $330 or 3.7%.
Options trading can be very risky when used speculatively, but options can also be used conservatively with a stock portfolio, hedging downsides and increasing portfolio income.