By Libby Dubick, President, Dubick & Associates
While most investors have some familiarity with options, there are some who consider them too risky and too complex. But the truth is options can play a strategic role in every portfolio-including those of conservative investors-once they know how they work and what they can do.
Reviewing the Fundamentals
As you may know, an option is a contract to buy or sell a specific financial product. In the case of equity options, for example, the option's underlying instrument or interest is a stock, exchange-traded fund (ETF), or similar product.
The contract establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. It also has an expiration date. When an option expires, it no longer exists or has value.
There are two types of options -- calls and puts -- and both can be bought or sold. The purchase of a call gives the owner the right, but not the obligation to buy the underlying security at the strike price on or before the expiration date. In turn the seller of the call is required to sell the security at the strike price at the buyer's request.
Conversely, the purchase of a put gives the owner the right, but not the obligation to sell the underlying security at the strike price on or before the expiration date. In this case the seller is required to buy the security at the strike price at the buyer's request. The type of option utilized, and whether it is purchased or sold, depends upon what the investor hopes to achieve.
Why Options?
Generally, high net worth investors use options in one of four ways:
1. Generate Income. You can generate income on your portfolio by writing covered calls, selling an option on stock you currently own. In exchange for the premium you will agree to sell your stock at a later date for a specific price. If the stock reaches the agreed upon price you must sell it, or buy more stock to cover it. (Read more about this strategy below)
2. Protect Portfolio Gains. If you want to lock in profits on a stock for a specific period of time purchasing puts can help. A put gives you the right to sell at a specified price within a specified time. This establishes a minimum selling price for the stock during the life of the puts.
3. Hedge a Position. Options can be useful when you have a large position in a single stock and want to shield it from the markets ups and downs. By simultaneously selling covered calls and purchasing puts, they form a "collar" around the stock to protect its price.
4. Diversify a Portfolio. To diversify a portfolio, you can buy either short or long-term calls on specific stocks. This gives you the right to buy the stock at a later date at a specific price. This is a less expensive approach than buying the stock outright, and may leave you better positioned to respond to market changes.
When to Use a Covered Call
Often, investors employ a covered call strategy where there is a stock that they are holding and want to keep as a long-term hold, possibly for tax or dividend purposes. The investor believes, however, that in the current market environment the stock value is unlikely to appreciate, or may even decline.
An added benefit of the covered call is that it can decrease the risk of stock ownership. In theory, this strategy will out perform outright stock ownership if the stock price declines, remains the same, or slightly increases in price. The principal disadvantage of this strategy, on the other hand, is that profit potential can be limited if the underlying stock price advances sharply.
Covered Call Writing in a Bear Market
If you think a stock you own will decline modestly in price in a bear market, but think it will rebound over the long term, you might write a covered call as an alternative to purchasing a protective put (to protect the price.) The premium you receive offers some limited downside protection.
- If the price moves down as you anticipate, and the call expires with no value, you'll keep any premium you received. That premium can at least partially offset any paper loss on the stock.
- If the stock price increases, your call might become in-the-money. If you think you might face assignment, you can always close out your option position by buying back the call you wrote, possibly at a net loss. However, you'll hold onto your stock and have an unrealized profit.
- If the option is exercised and you're assigned, you'll have to sell your shares at the strike price. That means you'll miss out on any future gains the stock may have. In addition, you may owe capital gains tax on the transaction.
Covered calls can be considered less risky than naked calls if the price of the underlying stock increases because you already own the underlying shares you'll have to deliver if assigned. You won't have to purchase them at higher-than-current market price. In other words, with covered calls the maximum upside risk you face is having your stock called away from you, which would mean missing out on potential future profits.
Wealth Management: Anticipating the Unexpected
Of course, in a bear market, the underlying stock could drop significantly in price. The written call, in this case, offers only limited downside protection, by the amount of the premium you received.
But if the price of the underlying stock increases unexpectedly, you always have the alternative of buying the option you sold, closing out your position and eliminating the risk of being assigned. This can result in a realized loss on your written call, but one that can be offset by any unrealized profit on the shares, which you keep.
