Options Can Help Insure Your Net Worth

I'm annoyed by hypesters who tell investors that options can be used to produce profits in any type of market.  And for a large fee, they would be happy to share their secrets.

The truth is anyone can make money consistently in any type of market – the problem is predicting the future, and knowing what type of market lies ahead.  That part is always neglected by those hypesters.

It's easy to tell option rookies that they should 'buy calls' in bullish markets or 'buy puts' in bearish markets, or 'sell straddles' in neutral markets. I'm sure you already know that it's not that easy.  In fact, it's extremely difficult to know what lies ahead.

401(k) plans have been decimated.  People talk about being unable to retire and how they must continue working – if they are lucky enough to remain employed.

The point is:  if it were so easy to generate huge profits using option strategies, more investors would be using options.

Instead of making outrageous claims, I prefer to teach option rookies that options can be used to reduce risk – and there's no need to guess where the  market is headed. 

Options can also be used to increase your chances of 'beating the market' on a consistent basis.  To accomplish those goals, it's necessary to sacrifice something because those benefits are  not available at zero cost.  The good news is that the cost is not in cash.  Instead the cost is usually (there are different approaches an investor can take) accepting a limit on potential profits. To me, limiting profits in exchange for limiting losses plus an increased chance of earning some profit is a good deal.  But it's not for everyone.

And that's a sticking point for many.  Becoming greedy during the technology bubble near the turn of the century, investors were unwilling to limit profits.  Sadly the bubble burst and those who lacked protection lost significant sums.

As the major market averages established new highs, and investors were once again making money, the need for portfolio insurance was once again ignored.  It's human nature.  No one wants to limit profits in an uptrend, but people get upset when the surprise bear market reappears.

If you never learned to use option strategies to protect your assets, a reasonable question to ask is:  Is this a good time to get started, or is the market about to give back a substantial portion of those losses?  I don't know the answer.  I wish I could help you find the best answer.  But, it's a personal decision.

If learning how to insure all or part of your portfolio appeals to you, it pays to learn about options.

This blog offers information to help you get started.  Visit my web site and begin with the discussion of the most basic concepts of stock options.

Feel free to post questions as comments.

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6 Responses to Options Can Help Insure Your Net Worth

  1. NG 11/23/2008 at 7:20 AM #

    Mark;
    Thank you for an honest and realistic information on OPTION.
    I agree with you 100%. I try to learn from your Blog every day. Please keep up the good work.
    One qestion I have:
    Is there such a thing as truly NEUTRAL MARKET?
    Even RUT and SPY has been very volatile recently.
    I hope you can throw some light on this MARKET NEUTRAL idea.
    Cheers
    NG

  2. Mark 11/23/2008 at 9:20 AM #

    NG,
    Thanks.
    Is there such a thing as a neutral market? Sure. that happens when the market trades in a narrow range. It’s happend before and will happen again. But when? It may be difficult to believe with VIX at 80, but it wasn’t too long ago that VIX was TEN and no one thought the market was going to be making a move any time soon.
    I am not suggesting that investing in index options makes you ‘market neutral.’ It’s up to you, the investor, to have a market neutral position. That means a position that neither makes nor loses money when the asset that underlies your options moves higher or lower.
    That is difficult to accomplish. Such a position should be delta neutral. But, you would want a position that is gamma neutral, theta neutral, vega neutral etc. That’s not for me and it’s not for you. That is for market makers who try to eliminate all risk from their portfolios. They make their money by buying options on the bid and selling on the offer – and staying neutral.
    What you can do is begin with a position that is neither bullish nor bearish when it is initiated. Such a position is a delta neutral iron condor. When the market moves, your position is no longer market neutral. But, it’s nearly that. At some point, if the move is large enough in one direction, the position may be too far from neutral that you are no longer comfortable holding it. At that point you should adjust the position, reduce the position, or close the position.
    But, if time passes and nothing bad happens, you can close the position and take your profit.
    As an iron condor trader, you want to see the passage of time offset market movement. In recent times, this has not happened.
    If you desperately want to be market neutral, you can adjust your deltas every day, but I do not recommend that. If buying iron condors is uncomfortable for you in this market (and it should be) then it’s okay to sit it out or find another strategy that appeals to you.
    Mark

  3. DP 11/23/2008 at 6:01 PM #

    Mark,
    This is great advice indeed. Like many of your readers, 6-12 months ago I was sitting on a nice profit in many stocks. I have a bad habit of selling winning stocks too soon for fear of “losing that profit” and selling losing stocks too late always expecting a rebound (talking normal market conditions, not the past 2 months).
    One example of many, in July CHK touched 69.40 a share. I had been holding 500 shares of CHK from $28 and was determined not to make the “sell too soon” mistake again. But at that point, over 100% profit, enough was enough and I decided I would sell when it hit 70. Other than briefly intraday, it never hit 70, and now it is 16. I don’t beat myself up over it, I made a plan and stuck to it.
    The thing I beat myself up over is being an uninformed investor. I knew nothing about options back then. Had I known about puts it would have been the perfect solution. Buy a $60 put (low volatility at that time, with a strike $10 OTM would have been cheap) and give myself a chance to take part in potential future gains with most of the profit so far locked in, a no brainer.
    If one good thing comes out of this crash for me, it is learning about Puts.
    Here’s another example. Citigroup at $3? I don’t think too many people would argue that by 2011 Citigroup will either be (a) 0, done, a footnote in history or (b) significantly higher than 3. Same applies to any high flying stock now on the ropes (LVS, DRYS, etc).
    Thanks to learning about options; on Friday I was able to buy Citigroup at 3 bucks and buy 2011 7.50 puts for around 5.50, making my total downside on this “gamble” a dollar with unlimited upside if Citi is over 8.50 (cost of trade) by 2011. I could have even sold 2011 covered calls in the 15 range to bring the overall cost close to break even with the potential for a double by 2011. No idea what the name of this play is (condor? butterfly? one legged Australian parrot?), but I know it makes sense to me seriously limit the risk on a binary outcome with the real cost being missing out on the first few dollars of a recovery in price of the underlying stock.

  4. Michael C. 11/23/2008 at 11:00 PM #

    Mark, a quick question: It seems to me that one of the most common uses of an option would be to buy calls on a stock that you think will be going up soon so that, if you are right, you have control over a much larger quantity of stock that you could have if you had just bought the stock. If the stock goes up like you thought can’t you “buy to sell” the stock? In other words, can’t you tell your broker that you want to exercise the option and cash it in? That’s generally what happens when you exercise a “gift” option from your employer. I know you said that you may buy the stock and that the money will be deducted from your account, but what if you don’t have that much in your account? Are you just out of luck, other than selling the option?

  5. Mark 11/24/2008 at 7:54 AM #

    DP,
    The good news is that you understand how options work today, and that gives you advantages for the remainder of your lifetime.
    NOTE: You could have also purchased the C Jan 11 7.50 calls instead of the stock plus put. It’s an equivalent position. But, your choice allows you to collect dividends, if the company declares them.
    Although I like the parrot suggestion, if you had sold the call, you would own a collar.
    I agree that limiting risk is essential, but you must also remember that risk is already limited when you buy a $3 stock. Yours is a reasonable play. Extremely limited downside risk in exchange for profiting from the ability of the company to recover.
    And if you decide to do so, you can sell calls later. But, the pre-opening good news for this stock will probably kill the implied volatility, and with it, the price of the options. You would have to wait for a good sized rally before selling any calls.
    I hope it works well for you.
    Mark

  6. Mark 11/24/2008 at 8:05 AM #

    Michael,
    A few comments.
    “Buy to sell” is not options terminology.
    Yes, you can tell your broker to exercise the options any time – after you buy them.
    But, please (please) understand that you do not have to exercise to ‘cash in.’ The best (by far) method for cashing in is to SELL THE OPTION. There is no need to exercise. Please refer to my recent blog posts (Nov 19 and Nov 21) on why it is wrong (almost all the time) for investors to exercise options.
    Employee stock options are different because you cannot sell them on an exchange. In fact, most employers establish rules prohibiting the sale of employee stock options.
    I don’t understand why you consider it to be ‘just out of luck’ when selling the option (exchange traded options, not employee stock options) gives you a HIGHER profit than exercising.
    In fact, I would go so far as to say that if you exercise, not only are you just out of luck, but you are also just sacrificing cash for no reason. But more than that – if you insist on exercising options – especially call options – prior to expiration, then you are also failing to take advantage of the characteristics of options that makes them so attractive to investors.
    I simply don’t understand why several people have suddenly been asking about exercising call options. DON’T DO IT. Sell those calls and lock in your profits.
    Mark