Options investing strategies aren’t just for traders but can protect your portfolio as well
Many investors avoid options investing, believing the myth that it’s just for trading and a quick profit. The truth is that some options strategies can be used to reduce your investing risk and make extra cash on your investments. Learning the basics of how options work and some of the strategies will mean new tools to protect your portfolio and meet your financial goals.
We’ll cover the basics of options investing in this post, along with a couple of options strategies for protecting your portfolio. In coming posts, we’ll go deeper into investment strategies and how to use options without gambling.
What is Options Investing?
Options are also called derivatives because they ‘derive’ their value from another investment. The two types of options, calls and puts, can be bought on most other investments including stocks and commodities. When you buy an option, you pay a premium in exchange for the right to buy or sell the underlying investment at a later date for a set price.
Call options are the right to buy an investment while put options are the right to sell the investment. Notice you get the ‘right’ to buy or sell a stock but not the obligation in options investing. This is important because it’s really where the value comes from in the investment.
For example, if you buy call options on shares of Apple for a strike price of $100 each and a June expiration. The strike price is the price fix to pay for the shares when the right expires in June. You might pay $5 for the right to buy the shares at that price, this is called the premium. No matter what the price of Apple does between now and June, you have the right to buy it at $100 per share. If the price jumps to $120 then you can buy the shares for $100 for an immediate gain of $15 each, the difference between the purchase price plus the premium you paid for the options and minus the current price.
If shares of Apple do not make it to $100 each, you don’t have to buy the stock for that amount. Your call options expire and you lose the premium but you can buy the shares for less than $100 in the open market.
Where call options are the right to buy something, put options are the right to sell something. If you buy a put option on shares of Apple, you pay a premium and have the right to sell the shares for a certain price. If the share price falls below your strike price, say that same $100 per share, then you can sell at that price even if the actual stock price is much lower.
You can also sell call or put options, collecting a premium from other investors. Selling options means you’re taking the obligation to be on the other side of the investment if the options buyer wants to use their right to buy or sell the stock. If you sold those call options on Apple stock in the previous example, you would immediately collect the $5 premium from the investor. If the share price jumps then you would be obligated to sell the investor shares of Apple for $100 each. If the share price fell below $100 then the investor wouldn’t use their right to buy the shares and you would keep the premium and do nothing.
Options investing can be confusing at first but can open up a whole new world of investing, both for trading and for reducing risk.
Isn’t Options Investing Just for Traders and Risky?
The biggest misconception about options investing is that it’s too risky for regular investors and should only be used by traders looking to make a quick profit. Sure, options investing can be risky if you don’t know how to use it but it’s a tool and can actually help you reduce your investing risk as well.
Buying and selling options without owning the related stock is called naked investing. This is where you are making a bet that the price of a stock will go up or down. You pay the premium for the options investing and collect the profits if the stock price goes the direction you predict. Since you can buy an option contract for a fraction of what it costs to buy the stock, your profits are increased greatly.
In our example above, buying shares in Apple would currently cost $104 each and you’d make a 15% return if the price went to $120 per share. If you instead bought the call options for $5 each, you could sell the call option to another investor instead of actually buying the stock. Since you’ve got the right to buy the shares for $100 and they’re currently worth $120 each, selling your call options would be worth at least $20 each for a profit of 300% on the investment!
Of course, if shares were to fall below the $100 strike price then you lose your $5 premium and get nothing while someone buying the shares would have a small loss but still own the stock. This use of options investing is risky and most investors don’t need the level of risk.
There is another way to use options investing though, a way to reduce your investing risk and generate cash from your investments. If you already own the related investment, then buying or selling call options can be a way to minimize the risk of falling stock prices. Think about it, if you own 100 shares of Apple and then sell someone call options then you give them the right to buy the shares from you for a certain price. If the share price rises, you make money up to the price you agreed to sell the shares. If the share price falls, you lose money on your investment in the stock but you keep the options premium which reduces the total amount you’ve lost.
Using Options without all the Risk
There are a few basic options investing strategies you can use to reduce risk in your investments. We’ll cover the basics here but check out the Optionshouse blog for more detail on how to use each.
A covered call strategy is owning shares of stock and selling a call option, described in the example above. It’s called covered because your obligation to sell the shares from the call option is ‘covered’ by your ownership position in the stock. The strategy limits your upside gain in the stock investment but can be a great way to reduce risk and make extra cash on your investment. Basically, the money you collect selling the call option lowers your cost in buying the stock. The share price might fall from your original investment price but you might still have a profit because your new cost is lower.
Another popular way to protect your investments through options investing is through buying puts. Remember, buying a put option gives you the right to sell a stock for a certain price. If you own shares of Apple but are afraid that the next iPhone isn’t going to be well received, you can buy puts. If the price falls, you’ve got the right to sell your shares for the higher price. You’re basically limiting your losses to the price you can sell through the put options.
For example, you own shares of Apple at $104 and buy the $100 put options. If the share price increases, you profit on the shares you own and do nothing with the put options. If the share price falls below $100 then you can still sell the shares for that amount. You have a slight loss since you bought at $104 but have limited your losses.
There’s another way to use put buying options to protect your whole investment portfolio and reduce your risk of a stock market crash. The portfolio put strategy is where you buy put options on the entire stock market, through puts on an index fund like the SPDR S&P 500 ETF (SPY).
The basics of a portfolio put strategy are pretty simple though the details can be a little more complicated. If you own a portfolio of stocks, the individual investments might rise or fall depending on company news but the overall portfolio value may move closer to the market’s gains or losses. This goes back to the important idea of diversification, balancing out investing risks by owning a group of stocks.
Now if you sell a put option on an index fund that represents the stock market, you have the right to sell it for a certain price. If the stock market tumbles, the money you make on your put options helps to offset the losses on your individual stocks. The website Personal Income offers a more detailed explanation of writing options and options strategies.
This kind of options investing is an indirect strategy to reduce your risk because your own stocks may not rise or fall exactly with the rest of the market. It could be a good thing if your stocks increase while the rest of the market decreases, providing a profit on both your stocks and the put strategy. The advantage to an indirect options investing strategy is that buying put options on a broad fund is usually cheaper than buying options on individual stocks.
This very brief summary of options investing is only a fraction of what you can do with options strategies, both for profit and to reduce your investing risk. We’ll cover more investing strategies in future articles including how to get a discount on stocks you want to buy and how to generate cash using options.