Call the put and put the call.
The stock market is being less than kind to investors this calendar year.
What do you do today if you are anxious about a further erosion of your capital? One idea is to use the option market to help protect your investments.
You can employ four strategies that will help you reduce risk, generate income and offer downside protection.
Covered Call Writing. In a covered call strategy, you can sell an option to generate income. This strategy will help offset a portion of the loss but will not give you complete downside protection. In a covered call strategy, you identify both the stock and the strike. Let’s say you own 1,000 shares of ABC company which is currently trading at $48 per share. The February $50 call option is currently selling for $1.00. This means you will generate $1,000 in income, before fees, for your account (10 contract = 1,000 shares). The $1,000 will help offset some downside in ABC stock. Of course, if ABC trades above $50 or more in February you will have to sell your 1,000 shares at $50. The best day to sell a call is when the stock market is escalating.
Selling Puts. This is the opposite of covered call writing. When you sell a put you are selling an option below the current price of the stock in hopes that it trades down to your level. For example, ABC is still trading at $48 per share and you decide you would like to own it at $45 per share. You can sell the February $45 put option for $1.00. If you sold 10 contracts, you would have generated $1,000 in income for your account. If ABC trades to $45 or lower, then you are obligated to purchase ABC at $45. This strategy works well in a declining market as you can wait for stocks to trade to your purchase level. It is important to only sell puts on companies you want to own as you will be obligated to purchase the shares if the stock trades below your strike price. The best day to sell a put is when the stock market is waning.
Purchase a put. To add downside protection for your stocks, you can purchase a put option. When you purchase a put option you add insurance. For example, if you want to protect your ABC holding at $48 per share, then you can buy a February $50 put option. If ABC continues to fall, your put option will get more expensive and help offset your loss. The best day to buy a put option is when the stock market is climbing. A put option is like home owner’s insurance in that you hope you don’t have to use it. If your stock does not go down, then your option will expire worthless. This strategy can get expensive if you are buying put options every month.
Option Collar. The option collar allows you to sell a call and buy a put on the same stock. By selling the covered call you can help offset the cost of the put purchase. For example, with ABC selling for $48, you decide to collar your stock. You would sell the February $50 call option and purchase the February $45 put option. The covered call may bring in a $1.00 while the put costs you $1.50. The net cost, before fees, is $.50 ($1.50 - $1.00 = .5). You have now collared your stock between $50 and $45. If ABC rises above $50 you will be obligated to sell the stock at $50. If ABC falls below $45, you are now protected to the downside for all prices below $45. The best day to add a collar is when the stock market is expanding.
You can buy or sell options that expire from a few days to a few years. As a seller of an option I would recommend a four to six-week timeframe. A purchaser, can expand this to four to six months.
As a reminder, the stock market has always recovered. It might take one week, one month or one year but it has always bounced back. If you need proof, please look at the following years: 1907, 1915, 1929, 1930, 1931, 1932, 1934, 1937, 1939, 1940, 1941, 1946, 1953, 1957, 1962, 1966, 1969, 1973, 1974, 1977, 1981, 1990, 2000, 2001, 2002 and 2008.
Options do involve risk and are not suitable for everyone. If is important that you work with an advisor that understands the characteristics and risks of option trading. For more information on option trading please visit www.cboe.com.
Bill Parrott is the President and CEO of Parrott Wealth Management, LLC. www.parrottwealth.com.