Stock Options Part II — Basic Strategies

In our ongoing series on money investing, we’ve previously covered stock option basics, so now let’s explore basic options strategies.  Options are like a gun — they can be dangerous, or alternatively they can be used as a critical defense.  When employed for speculative purposes, call and put options entail great risk — but also substantial potential rewards.  Conversely, when used as a part of a defensive strategy, they can serve to reduce risk.  All institutional and shrewd individual investors use options at one time or another to hedge existing risk within their portfolio.

Covered Calls

Covered calls are a part of strategy of the risk you incur when you purchase a stock.  Assume you desire to purchase 100 shares of stock ABC which is trading at $25 per share.  However, you are hesitant to pull the trigger and are going back and forth on whether this is a good trade or not.  One avenue is to buy the stock and hedge some risks by selling covered calls.  Assume you are purchasing 100 shares of ABC at $25.  The $30 strike price call options expiring 6 months out are trading for — say — $3.  If you buy 100 shares of ABC at $25, then sell 1 contract of this $30 call option — then net you paid only $22 per share.  So, if ABC ends up going down $3 to $22, you actually end up breaking even as opposed to losing money as you would have if you just bought the stock without selling the covered calls.

However, by selling the $30 strike price calls you are obligating yourself to part with the stock if it goes above $30 upon the contract’s expiration.  Your net price being $22, you still make $8 per share on the trade if it goes above $30.  This decreases your maximum potential profit — for example, if ABC goes to $100 you would have made far more money had you not sold the covered calls.  However, you are decreasing your risk by giving yourself the “free” $3 you get by selling the call contract.  Covered calls are excellent for trades where you aren’t 100% sure and want to use call options defensively in order to reduce risk.

Married Puts

Married puts are a defensive options strategy using put options to defray risk associated with owning a stock.  Take again the above example of ABC stock trading at $25.  You desire to purchase, but are less than certain in your conviction.  As an alternative to covered calls, you can buy what is called a married put.  Assume the $20 puts expiring 6 months out are trading at $3.  You can buy 100 shares of ABC at $25, then also buy 1 contract of this put option for $3 making your total in-price $28.  So, you are giving up your first $3 of profit — at $28 you are even.  But, you are also getting the right to sell at $20 valid for 6 months.  So if ABC turns into a Madoff and completely blows up, you can exercise your right to sell for $20 saving yourself from a huge loss.

You can think of a married put as an insurance policy.  If the thought of the stock melting down and going under $1 (it can happen to ANY stock) makes you too nervous to buy it, you can use a married put selecting your risk tolerance via choice of strike price.  This limits and defines your potential loss allowing you to sleep at night — in return for the cost of the option purchase.

Collar

A collar consists of doing both of the above within a single position.  Using ABC trading at $25 as the example again, you would buy 100 shares, sell 1 call contract and buy 1 put contract.  The amount collected selling the call equals what you pay for the put causing you to break even putting on this collar.  The result is that you are obligated to sell at $30 limiting your potential profit to only $5 per share — but you also have the right to sell at $20 which limits potential loss to only $5 as well.  This entails far less risk than just buying the stock at $25 in which scenario you could potentially lose the entire $25.

A collar is a defensive move which limits your upside, but also significantly limits your downside.  No doubt many of you who have traded stocks for any duration of time can think of given trades which you’d give anything to have put on a collar.

TAGS: , ,

0 Comments



You can be the first one to leave a comment.

Leave a Comment