You’ve probably heard people refer to options as a risky venture, similar to gambling. And it’s 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 the use of options in your portfolio. But that doesn’t mean that options can’t play a role in a conservative portfolio of stocks.
Most of today’s options trading volume stems from institutional money managers who use options to protect their clients’ equity portfolios. They are using options like insurance. Options can also be used to increase the income that can be derived from a conservative portfolio of stocks.
Stock options written are called stock options and come in two forms: call and put options. 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 grocery store 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 entitles you to purchase 100 shares at a specified price and is only valid for a specified period of time.
Put options are the opposite of call options and are more like insurance; A put option gives the owner the right to sell the underlying shares at the option’s strike price at any time before expiration. Put options are often bought when one expects a stock to drop in price, or it could be used as a form of insurance if I already own the stock; If my shares go down in price, my put option appreciates and compensates for 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 expires worthless, just as my put option will expire worthless if my shares continue 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 falls in price, 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 that third Friday. While that is not technically correct, it is true that Friday is the last chance to trade those options. The expiration was set on Saturday to give the Options Clearing Corporation and brokerages 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 June call option of $ 35 was quoted at $ 1.00 at closing. In option quotes on a site like Yahoo Finance, you will see the bid and ask prices posted. The offer price is the price quoted if I want to buy the option, while the offer price is what I would have to pay to sell my option. Options are priced per share of the underlying shares, but are sold as contracts covering lots of 100 shares. June XYZ calls of $ 35 are trading at a asking price of $ 1.00. Each contract is priced at $ 1.00 per share of the underlying shares; Since each contract covers 100 shares, the contract costs $ 100 and five contracts would cost $ 500. I have the right to exercise my options at any time before they go down on Friday, June 19, and buy 500 shares of XYZ at $ 35 per share or $ 10,500. Or I could simply 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 portfolio of stocks. For example, if I own 300 shares of XYZ, but I am concerned that this market is weakening and may fall again, I could buy three contracts of the June put options of $ 35 to $ 1.40 to protect my position. This sell position would cost me $ 420 and would protect me until June 19. As the price of XYZ goes down, the price of the put options will increase, offsetting some or all of my loss in the shares. This is called a “married position” 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 believe that the stock will be trading sideways or slightly higher for the next several weeks, I could sell three contracts from the June calls at $ 35 for $ 1.00, which will bring $ 300 to my account. If XYZ is trading unchanged at $ 34.70 on June 19, the $ 35 call options will expire worthless, and I will have made $ 300 or 2.9%. But if XYZ is trading above $ 35, my maximum profit is capped at $ 330, or 3.7%.
Option trading can be very risky when used speculatively, but options can also be used conservatively with a portfolio of stocks, both to protect downsides and to increase portfolio income.