Conservative Options Strategies That Might Be Safer Than Stocks
A stigma attached to options is that they are extremely risky financial instruments. The truth is that options are only as risky as the strategy built from them. You can actually create a highly conservative strategy with options despite their risky stereotype, resulting in a position that is even safer than a pure long stock position.
- Conservative Options Strategies That Might Be Safer Than Stocks
- Options 101: What are Puts and Calls?
- Are Options a Good Strategy for Conservative Investors?
- Puts and a Protective Put Strategy-Insurance
- Covered Calls-Make Money
- Conservative Options Strategies – Wrap up
Option Investing Can Increase Your Overall Returns
Buying a call option gives you control over many shares of stock with a limited amount of cash. You cannot lose more than you pay for the options contract. For conservative investors, a covered call on an existing position can boost the overall expected return. Buying put options can limit your losses in the event of a market downturn, acting similarly to an insurance product.
Although investing in stock options can be a conservative or speculative strategy, this article examines only conservative options strategies.
Options 101: What are Puts and Calls?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties. ~Investopedia
Call Options Explained
A call option gives the option buyer the right to buy a stock, bond, commodity, or ETF, the underlying asset, at a specific price within a predetermined time period. The call option buyer does not have to buy or exercise her right. This strategy might be used if you expect the asset to increase in price.
The call option seller or writer receives a premium or payment for the buyers right to purchase the asset. The seller also has to be prepared to sell the option at the designated price, so don’t sell an option on a stock that you want to continue holding. This strategy is for sellers who plan to sell an asset anyway and want to earn extra money.
Put Options Explained
A put option is a contract that gives the option buyer the right to sell a specific amount of an underlying security – stocks, currencies, bonds, commodities, futures, and indexes – at a specific price called the strike price, within a predetermined time period. Like the call option, the buyer is not required to exercise or sell the security. In this case, the the buyer of a put expects the asset to drop in value.
The put option writer, or seller requires an investor to be willing to purchase shares of the underlying asset at the strike price stated in the option contract, should the put option buyer decide to sell. You would sell a put if you believe the underlying asset’s price will increase.
Options enable investors to control a greater amount of assets with a smaller amount of money than an outright purchase or sale of the shares would require.
Are Options a Good Strategy for Conservative Investors?
Option strategies allow you to control your risk exposure to a given equity. Buying a call option, for example, gives you exposure to a number of shares of stock but at a limited absolute risk – namely the price of the call option. That is, the max loss you can experience is the cost of the option, which is usually to the tune of hundreds of dollars, unlike a lot of stock, which usually requires thousands of dollars.
A conservative investor can use call options to gain exposure to large returns but at a lower risk than buying stock outright. Likewise, buying put options can act as insurance when markets fall. The short of it is that options can be used in a conservative investment strategy, provided you have the correct options strategies in your toolbox.
If you want to try your hand at conservative options strategies, you might start with a paper trading account, to hone your options trading skills.
The following options strategies might be conservative, especially if you have a sense of the future market direction.
Puts and a Protective Put Strategy-Insurance
Puts protect your portfolio’s holdings against a loss in value. The holder (owner) of a put has the right to sell an asset, such as a stock, at a certain price within a certain period of time at a specific price (strike price).
Here is an example: Walmart stock is selling for $143.25 today. You pick up as many shares as you can afford at that price. If the stock price goes up and you sell and receive the profit between your buy and sell prices. If the stock price falls and you sell, you lose.
Assume you own Walmart and think the shares are going to decline in price over the summer, but you do not want to sell your shares. You can buy insurance – aka a put – to protect yourself from loss, while still holding the underlying shares. Owning a stock and buying a put is called a protective put strategy.
You can buy 1 put contract (which gives you the right to sell 100 shares) with a strike price of $145 and an expiration of March 18. The price for this contract is $6.00 per share, which equates to $600 total (because a put contract is meant for 100 shares). This means that you have the opportunity to sell 100 shares of Walmart at $145 any time before March 18.
This is protection against a loss if Walmart shares drop in price. On March 18, if Walmart shares are selling for $140 in the marketplace, you can sell your shares for $145. Your profit would be $145 per share less the amount you paid for the shares (and the cost of the option contract). On the other hand, if Walmart shares continue to sell above $145, your total loss is the price of the option contract, or $600.
This is kind of like buying insurance for your car. You pay $500 per year to insure your car. If you don’t have a claim, you lost the $500. If you have an accident, the insurance company reimburses you for your loss. You are protected against a greater loss.
Pros and Cons of Protective Puts
- Protects your profits without requiring you to sell shares.
- Cheap for insurance; often costs only a couple percentage points of the price of the stock itself.
- One put protects one lot (100 shares) of stock, meaning if you have an odd number of shares (e.g., 166), you cannot get 1-to-1 protection.
- You need the stock to rise more strongly than otherwise after buying puts, so as to compensate for the premium paid for the put.
Covered Calls-Make Money
Buy a call and you have the right to buy an asset at a certain price within a specific time period. Buying calls is often a speculative strategy.
An alternative is to write (sell) a call on stock you already own to boost your income. This is a Covered Call and a conservative strategy that can be implemented when you do not expect a stock to rise quickly; instead of letting your capital sit in a stagnant stock, you are creating income at the expense of the potential maximum upside reward. The buyer of the call pays you for the option to buy the stock from you at a specific price within a limited time period.
This strategy is great if you are planning to sell a stock anyhow and want to boost your return a bit. Covered calls are frequently used by portfolio managers.
For example, if you own shares of Walmart (price $143.25) and are considering selling when they reach $145, you can sell (write) a call giving the purchaser the right to buy the shares of Walmart at $145. You will receive $4.40 per share or $440 for one contract (100 shares). If the shares trade above $145 before March 18th, you must sell them for $145 as the call holder will exercise the option. If they do not trade above $145 before March 18th, you keep the shares.
Either way, the $440 call option premium is yours to keep.
Pros and Cons of Covered Calls
- Great for when you have a price target for your stock (this is the strike price you choose and is where you achieve max profit).
- Allows you to “rent out” your stock for profit while the stock price remains stagnant.
- The premium offsets potential losses wi downside protecion for small pull backs.
- Caps your maximum gain.
- Offers no downside protection in the case of a significant pullback.
- Should the stock rise above the strike price you’ll sacrifice additional price appreciation when your stock is called away.
Conservative Options Strategies – Wrap up
When you invest in the stock market, you are essentially holding risky assets. Covered calls and protective puts can act as important tools for managing that risk. While trading options indeed can be risky, an options strategy meant for a risk-averse investor can additional income to your portfolio in while positioning it to conservatively reach your financial goals.
As opposed to being long stock, employing a conservative options strategy leads to less risk, a lower chance of losing money, and reduce the worst-case scenario of your positions. For a covered call, selling calls for the option premium is not highly risky and has the same maximum loss as a long stock position. For a protective put, a put option at a strike price lower than the current stock price can protect your underlying stock from its potential maximum loss, thereby reducing your position’s risk.
These sort of option strategies are ultimately beneficial to the investors who employ them wisely, and thus the educated investor need not fear the perceived risk that comes with options trading.
There is no “safest” option strategy because all strategies – aside those employing arbitrage – have the possibility that you might lose money. A common misconception is that the covered call is the safest option strategy; in fact, it might not be safer than a long stock position, as both strategies expose you to unlimited downside risk. Still, a covered call does lower your breakeven price and reduces losses and is thus a form of downside risk hedging.
“Conservative option strategies” refers to the basket of option strategies that help you conserve your capital. They can be as simple as buying a protective put, which acts as insurance to protect your long stock position; or they can be as complex as an iron condor spread, which allows an investor to profit as long as a stock is trading within a specific region by a certain expiration date.
The probability of an option strategy paying off relies on the movement of the underlying stock and is thus hard to predict. However, for certain types of movements, we know mathematically which option strategies lead to the highest likelihood of profitability. For example, if you expect a stock to trend sideways or move up (read: not fall), writing covered calls with the call’s strike price lower than the stock’s price almost always produces a gain, though this gain comes at the expense of capping your upside profit potential and with downside risk equal to holding long stock. Other strategies, such as the complex “ladder” strategies produce the highest probability of profit for directional positions.
Ultimately, for most investors, these probability calculations matter less than the risk-hedging that conservative option strategies bring to the table. Investors just getting started with options in the stock market should take it slow, starting with some of the simple option strategies outlined above.
- Investing in Real Estate Notes Guide
- How to Invest and Make Money Daily
- Should I Buy a Bitcoin ETF?
- Mutual funds vs Exchange Traded Funds | How to Choose
- Speculative Investments | What Percent Should I Invest?