Option Strategies For the Small Investor

During the market decline of 2008, I blogged about why the average individual investor should learn to use options to protect the value of his/her stock market portfolio.

However, options are contracts that cover 100 shares per contract, and many investors own less that than minimum.  The question is, can those investors also benefit from using the versatile investment tool – options.

The answer is yes.

When you own 100 shares of a specific stock or ETF, you can buy or calls or puts.  If you trade one-lots (a single call, put, or combination), then you can adopt a specific strategy that offers partial, or complete insurance against losing a large chunk of your investment in that stock. 

For example, you can write one call option and adopt the covered call strategy.

Or you can write one call and buy one put to establish a collar.

But, there's no specific strategy geared to investors who own odd lots (less than 100 shares) of various stocks.  Sometimes you can get around that limitation, depending of the nature of your portfolio.

Suppose you are an investor in tech stocks.  If you own a few shares of GOOG and perhaps 10 shares of AAPL and 20 shares of RIMM, then you have a portfolio worth about $3,000 devoted to tech stocks that have significant representation in the NASDAQ 100 index – the underlying asset for QQQQ.

Thus, if you sell one Jan 30 (or any other) call, you would have a position that approximates a covered call.  It's not exactly a covered call, but if you want a small amount of downside protection and are willing to sacrifice a large upside profit in return, this trade provides something similar to a covered call.  NOTE:  Your broker will consider this to be a naked call option, and may not allow the trade.

Important NOTE:  I chose the call with the 30 strike price for a reason – and it's not because it is the call option that's at the money.  Your portfolio is worth about $3,000 and the Jan 30 call covers $3,000 worth of QQQQ.  If your portfolio is worth $6,000, you can write two of those calls.

Similarly, you could write one Jan call (perhaps the 31) and buy one January put (the 28??).  That would give you a position that is approximately a collar.  Choose strike prices that suit you and your comfort zone.

If you own a more diversified portfolio of large capitalization stocks, you can trade options on SPY in a similar manner.  The underlying asset for SPY options is the S&P 500 index.  Keep in mind that it takes a portfolio that's worth about $9,000 before you should consider writing one call.  SPY is currently 88 and one call option represents roughly $8800 worth of stock.


Warning

The correlation is not 100%, and these trades can easily result in losses (or gains) that are a bit higher than anticipated. But you would gain some of the benefits of the option strategy.

This point is vital:  You cannot just do this with any stock portfolio.  There must be some expectation of a high correlation with the performance of your specific portfolio and the index whose options you trade.  Don't fall into the trap of believing that any old index will do.  And please be certain you understand the specific strategy – before making trades with real money.

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