MBA Series: Options for Conservative Investors
As I teach Investments to undergrads and MBA candidates, I’m reminded of the practicality of investing. Growing your wealth through investing is an age old strategy and must be considered by anyone looking to build a long term nest egg. I usually talk about the conservative approach of index fund investing with an asset allocation aligned with your risk tolerance.
Here’s a quick review of investing basics:
- Figure out your risk tolerance.
- Create an asset allocation in line with that risk tolerance, more bonds and cash for the risk averse, more stocks for those more comfortable with risk.
- Populate the portfolio with low cost index funds, in line with your preferred asset allocation.
- Rebalance annually.
Don’t see anything about options do you?
This article will teach you about buying Put Options to temper the losses in your portfolio if stock values decline and selling Call Options if you think the stock market will trade in a narrow range. Options can be speculative and they can also be conservative investment strategies. Personally, I’ve written (sold) call options on stocks I already own and I was considering selling. Using this strategy, I made a bit of extra cash in my investment portfolio.
This article is best for more advanced investors, so if it’s not for you, choose another investing article.
Option Investing Can Increase Your Overall Returns
Buying an 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, selling call options on an existing portfolio can boost the overall portfolio returns. Buying put options can limit your losses in the event of a market downturn, similar 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
Puts and a Protective Put Strategy-Insurance
Puts are protection 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).
Walmart stock is selling for $74.74 today. You can pick up as many shares as you can afford at that price. If the stock price goes up and you sell, you benefit. 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 or 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 control of 100 shares) with a strike price of $75 and an expiration of August 13. The price for this contract is $2.00 per share or $200 plus commission. This means that you have the opportunity to sell 100 shares of Walmart at $75 any time before August 13.
This is protection against a loss if Walmart shares drop in price below $75. On August 13 if Walmart shares are selling for $70 in the marketplace, you can sell your shares for $75. Your profit would be $75 per share less the amount you paid for the shares (plus commissions and the cost of the option contract). On the other hand, if Walmart shares continue to sell above $75, all you lost is the price of the option contract or $200 plus commission.
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 and the insurance company reimburses you for your loss. You are protected against a greater loss.
Covered Call Strategy-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 a speculative strategy.
On the other hand, you can write (sell) a call on stock you already own in order to boost your income. This is a conservative strategy. The buyer of the call pays you for the option to buy the stock 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. This covered call strategy is frequently practiced by portfolio managers.
For example, if you own shares of Walmart (price $74.74) and are considering selling when they reach $77, you can sell (write) a call giving the purchaser the right to buy the shares of Walmart at $77. You will receive $.46 per share or $46 for one contract (100 shares). If the shares trade above $77 before August 13th, you must sell them for $77 as the call holder will exercise the option. If they do not sell above $77 before August 13th you keep the shares.
Either way, the $46 call option premium is yours to keep.
If you are interested in learning about options and practicing options trading with virtual currency, go to the free information and education site, the Chicago Board Options Exchange (CBOE) and set up a practice account or watch a few tutorials.
Have you ever thought about trading options? What has been your personal experience?
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