Option trading is typically associated with three different investor types. There are hedging strategies employed by large institutional investors, income-producing strategies for cash flow investors, and more aggressive trading strategies favored by speculators.
But where the does the long term investor fit in? Are there any option trading strategies that the conservative investor can employ to enhance his or her long term returns?
In fact, there are.
Leveraged Investing
There are actually a number of option trading strategies that can be employed by the long term investor. Leveraged Investing is the name I've given this approach, and these are the strategies I use myself.
The point of Leveraged Investing is to use options to acquire stock for a discount and then to generate additional returns above and beyond the actual performance of the stock itself.
Here are just two examples:
[Please note: in the interest of simplicity, commissions have been excluded from all examples.]
Example #1 - Writing Covered Calls. Writing covered calls is a popular, and generally conservative, income-producing strategy. A call option gives the holder the right, but not the obligation, to purchase 100 shares of the underlying stock at a certain price (strike price) by a certain date (expiration date).
Conversely, when you write, or sell, a call option on shares that you own, you sell (you receive a premium in the form of cash) someone else the right to purchase your stock at a certain price at or prior to the expiration date. If you own 100 shares of a stock trading at $28/share, you could write a $30 covered call expiring in one month. If the stock closes above $30/share, you'll be obligated to sell your shares for $30/share. But if the stock closes at or below $30/share, the call option will expire worthless and you're free to repeat the process. Either way, the premium received is yours to keep.
Writing covered calls is a great way to generate additional income from your investments, but the long term investor must take extra precautions to avoid being called out and forced to sell his or her long term holdings (I call one such precaution, The 1/3 Covered Call Writing Strategy--it basically consists of writing covered calls on only a portion of your portfolio in order to give yourself greater flexibility and protection against sharp moves higher by the stock).
Example #2 - Writing Puts to Acquire Stock at a Discount. A put option, in contrast, gives the holder the right, but not the obligation, to sell 100 shares of the underlying stock at a certain price by a certain date. When you write, or sell, a put, you're essentially insuring someone else's shares against a drop below the agreed upon strike price.
Like writing covered calls, writing puts can be a great source of income. In fact, the risk-reward profiles for writing puts and writing covered calls are essentially the same. Whereas call writers may write calls out of the money, at the money, or even in the money (the most conservative approach), put writers will typically write out of the money puts (e.g. writing a put with a $30 strike price on a stock currently trading at $32/share).
But for the long term investor, income is of less importance than the opportunity to buy a stock at a lower price that what it's currently trading at. Writing an at the money put will greatly improve the likelihood of acquiring the stock, and you'll also receive the most pure premium.
Example: Suppose you write an at the money put on a stock that you really like. If the stock is trading at $30/share and you write the put at the $30 strike price for, let's say, $2.50 in premium (or $250 in cash since each option contract represents 100 shares of the underlying stock) you're setting yourself up for a win-win situation. That's not to say you can't lose money on the deal, but look at the two possible scenarios.
- If the stock closes at $30/share or higher, you keep the original premium you received (which, in our example, represents an approximate 8% return in one month). You're then free to write another at the money put for additional premium.
- If the stock closes below $30/share, factoring in the premium you received, you end up purchasing the stock for $27.50/share. Obviously, if the stock gets cut in half, the premium you received will be small consolation, but what if the stock merely slips down to $29.50/share? You thought it was a good deal at $30/share and now you've acquired it for $2.50/share less.
Conclusion:
As they say, options involve risk and may not be suitable for everyone. But not all option trading strategies have to be high risk propositions. Some approaches, in fact, may offer substantial benefits for the conservative investor. If you are a long term investor, it may be worth your while to conduct additional research to see if there should be a place in your portfolio for options.
About The Author:
Brad Castro is a practitioner and promoter of Leveraged Investing, or option trading techniques and strategies designed to simulate successful value investing. Leveraged Investing has two objectives: to acquire stock in quality companies as cheaply as possible and then to squeeze more returns from those stocks once they've been acquired. Please visit http://www.great-option-trading-strategies.com for more information.
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