Options from a Different Perspective

Today’s blog is intended for
visitors who know nothing about options – and especially for people who believe
that options are only used by speculators.

 

Every year you pay a premium
to renew your insurance policies.  Do you
know the probability of losing your home to a fire or other disaster?  Does it really matter?  You buy insurance for the peace of mind it
provides because the thought of losing your home is so emotionally devastating
that you cannot also afford the financial loss.

When you buy insurance, you
are making a bet with an insurance company. 
The company bets you are going to live (life insurance) or your car is
going to avoid accidents, and you take the other side of the wager.  You don’t want to win these bets and you hope
to lose money on the premiums you pay. 
But you pay good money for those policies to gain the protection they
provide.

All financial advisors agree
that owning insurance is necessary.  The
cost of that insurance is seldom discussed. 
How would you like to insure your valuables and get paid to do so?

Did you know you can insure
your IRA or other investments?  It’s
readily available and depending on the size of the deductible, it can cost much
less than traditional insurance.  In
fact, you can obtain this insurance at no cost. 
Why haven’t you heard about this type of insurance before?  Is it a secret?  I believe it’s because there are no high-commission
salespeople pushing it. 

Your stockbroker, or
financial advisor should be able to tell you all about portfolio insurance, but
many lack the knowledge.  Many investing
professionals don’t understand how the versatile investment tool, the stock
option, can be used to insure the value of your portfolio.  That’s a shame because too many investors get
hurt for no reason when the stock market tumbles – as it periodically does.

Let’s assume you are a
conservative investor who owns a diversified stock portfolio.  There’s more than one strategy you can adopt
to provide that insurance protection you deserve.

 

METHOD ONE: Pay a premium to
buy put options

If your insured car is
destroyed in an accident, you can sell that car to the insurance company for
its replacement cost.  When you buy a put
option, you can do the same – i.e., if your investment becomes damaged (if
its value drops below a predetermined level) you have the right to sell that
investment at its insured value.

  • You own 100 shares of YZY, currently
    priced @ $115 per share.
  • Buy one YZY put option with a strike price of 115.  Puts trade on an exchange, just like stock.

The put
gives you the right (for a limited time) to sell 100 shares of YZY @ $115 per
share.  (You may choose different
deductibles and time frames.)

You are
not obligated to sell your shares at that price, but you have the right to do
so.  Thus, during the lifetime of the put
option, you may always collect $115 per share, no matter how low the price
drops.

The good news.  When
you own this insurance you have complete protection – i.e., you can always sell
your shares at $115.

The not-so-good news.  This
insurance is not cheap, and the price of the put option depends on several
factors.  In the example, you may have to
pay $150 for a 6-month policy.  If you
buy this protection again and again as the years pass, the costs become overwhelming.  But, that’s true of any
insurance policy.

Is it worth the peace of
mind?  For some investors, the cost is
reasonable.  For others, it’s far too
costly.  But, there are
alternatives.  One such alternative
involves a different strategy.  Instead of
paying a premium to gain complete protection, you can receive cash and
gain limited protection.

METHOD TWO:  Receive cash and gain limited
protection.  Sell a Call Option. 

If you don’t like the idea of
paying for insurance, you can be paid for accepting less insurance.  When you sell a call option, you receive
a cash payment, and that cash is yours to keep. 
In return for the cash, you grant the call buyer the right to decide if and when he/she buys your shares at the call strike price.  You have no say in that decision.

This agreement has two
possible outcomes:

  • If the call owner chooses to buy, you must sell. 

  • If the call owner decides not to buy, the
    option expires and you keep your shares and the cash.


Example
  • You own 100 shares of YZY, currently $115
    per share
    Sell one call option with a strike price of $115.

    That call grants
    the buyer the right to buy your shares @ $115 for a limited time. (You may
    choose different sale prices and time frames.)

    You collect a $200 cash premium of ($2.00
    per share). 

    The cash ($200) represents your limited
    insurance against loss. 

    If
    YZY rises, or declines by less $2 per share, you earn a profit

    If
    YZY declines by more than $2 per share, you lose money.  Thus, protection is limited.When option expiration day
    arrives, there are two possible outcomes:

Scenario 1. Your YZY shares increases in value and are
above $115 per share.

The
call owner buys your 100 shares and you receive $11,500.

You
also keep the $200 cash premium.  Net to
you: $11,700.

Scenario
2.
SPY is below $115

The
call owner refuses to buy your shares and the option expires.

You
keep the cash premium.

Both results are good. In the
first scenario, you sell YZY and keep the cash you received for selling the
call, raising your sale price (to $117 in this example).  When you entered into this arrangement by
selling the call option, you were willing to sell at this price, so you should
be satisfied.
In the second scenario, you
continue to own your YZY shares.  By
selling the call option, you are better off by the $2 per share cash.  If you apply that cash towards your original
purchase price, your shares now cost $2 less. You don’t have as much
protection when selling the call option. 
Thus, if YZY had dipped to $110, you incur a loss, but that loss is reduced
by the premium collected

  • You can insure your stock
    market portfolio.  You may elect to pay
    cash and buy complete protection.  Or,
    you may collect cash to gain partial protection.

    There is much more to learn
    about options and how they can be used conservatively to protect your family’s
    financial assets.  For example, you may
    decide to both buy the put and sell the call. 
    That’s known as the collar strategy and a more detailed discussion can
    be found here.
     

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4 Responses to Options from a Different Perspective

  1. Alex - My Trader's Journal 09/02/2008 at 3:54 PM #

    Good post. I don’t consider selling covered calls “insurance” though. I think it’s a great way to reduce your cost and thereby reduce your risk some, but the full downside to $0.00 is still there.
    I sell puts and calls just because I prefer to be the insurance company and collect premiums. I’ve always like that analogy too.

  2. Evelyn 09/02/2008 at 8:51 PM #

    What’s the difference between covered calls and naked puts?

  3. Mark 09/03/2008 at 1:07 AM #

    Alex,
    If a covered call ‘reduces your risk some’ – isn’t that the same as getting a small amount of insurance?
    Selling puts and calls is a different strategy – and you neglect to mention whether you sell a naked strangle, or if you also own stock.
    If you own 100 shares of stock and sell one call and one put, that’s the same as doing two covered calls.
    Thanks for the comment.
    Mark

  4. Mark 09/03/2008 at 11:17 AM #

    Evelyn,
    1) A covered call consists of owning 100 shares of stock and selling one call option. That option gives someone else the right to buy your 100 shares at a specified price (strike price) for a limit time.
    2) When you sell a naked put option, you are giving someone else the right to force you to buy those same 100 shares at the strike price.
    If the expiration date and strike price are the same, then from a risk/reward perspective, these positions are equivalent. Neither is ‘better’ than the other.
    When you choose the CC, you buy stock NOW; when you choose the naked put, you may become obligated to buy stock LATER. Thus, it’s important to keep cash on hand so you are able to buy the stock, if you are eventually forced to do so.
    Some brokers don’t allow customers to sell naked puts (the broker’s mistake, in my opinion).
    Mark