Legendary financier and investor, Bernard Baruch, was known to say; “I made my money by selling to early”. If that were the case, Bernard would probably not have much of a position in the stock market right now. The Nasdaq, Dow and S&P 500 all sit near record highs. Many investors have considerable unrealized gains, as a result. Looking at stocks at this level, one has to wonder if this is the top. Maybe it is, but no one can pick the exact top of the stock market. Rallies tend to overshoot. Is there any way to heed Bernard’s advice, while still making money, if stocks keep going up?
Yes, there is. Options can be used to hedge away potential losses, from owning a stock, while still reaping the gains. Some investors bristle at the thought of getting involved with instruments branded with the dreaded “D” word, derivatives. They shouldn’t. Options that trade on exchanges, such as the CBOE and AMEX are designed to be used by individuals and institutional investors, alike. The key is understanding how to use them. These three simple, option strategies will protect your profits on a stock, while allowing you participate in it’s price appreciation.
Buying Protective Put Option
A put option gives the owner the right to sell a set amount of shares at a set price, within a certain time frame. The set price is called a strike. The last day to sell is called the expiration date. The buyer of a put option, pays what is called a premium to the seller. Each put option is called a contract. Each contract, gives the put option buyer the right to sell one hundred shares of stock. When the buyer implements his right to sell the shares to the seller, it is called exercising the option contract. The instrument the options trade off of, are called the underlying. In this case it is the stock.
Put options for stocks, trade on exchanges, where the premium price is set by buyers and sellers. The strikes and expiration dates are set by the exchange and are not negotiated by the buyer and seller. A put option, with a strike price below where a stock is trading at, is said to be out of the money. This is because the owner of the put will not exercise the option contract, since he can sell at a higher price in the market.
Lets say an individual investor owns 200 shares of Pfizer stock. Its trading at 34.50. The investor wants to protect himself from the stock going down, but he is not sure if he wants to sell outright. There are out of the money put options on Pfizer, with a strike price of 33, that expire in two months, trading at 0.56 on the CBOE. The investor could buy two of these option contracts. He would pay $112 (2 X 100 X 0.56). This would give the investor the right to sell the 200 shares of Pfizer, within the two month time period at 33 a share. If The stock price drops below 33, within the two month time frame, the investor may exercise the option contracts. The seller of the premium would then need to take delivery of the shares, at the strike price.
A call option is the same as a put option, only instead of having the right to sell the underlying stock, the option owner has the right to buy the stock. Call options with a strike above the stock market price are out of the money. This is because buying the underlying at the market, is cheaper than buying the stock at the strike price. Therefore, the call option will not be exercised.
The same investor from above, can sell 2 out of the money 36 strike Pfizer call options, expiring in two months, trading at 0.56. The investor collects the $112 premium. If the stock rises above the strike price, before expiration, the investor delivers the 200 shares of Pfizer he owns, at the higher price. If the stock stays below the strike price, the investor keeps the premium. This type of trade is called a covered call. The investor owns the shares and is selling calls against them.
The investor gives up potential gain on price appreciation above the strike price. This is in exchange for some protection against the stock going down, in the form of the premium received.
A costless collar is a combination of a long put and a covered call. The proceeds from selling the covered call are used to purchase the put options. Thus, the term “costless”.
Our investor would sell the 2 36 strike, Pfizer call options, at 0.56 a piece. Then, he would use the proceeds to buy 2 33 strike Pfizer put options at 0.56. He has effectively paid for his put options, by agreeing to sell his shares, if his Pfizer stock appreciates above 36.
Think about transaction costs, when implementing these strategies. For example, implementing a long put, should cost you less commission then entering a stop loss order. If not, consider implementing the stop loss order instead.
Research how profits and losses are taxed. For example, how is the premium received on a covered call taxed? Is it a capital gain or income?
How To Get Started
Getting started is simple. Most brokers have levels of option trading that you need to be approved for. If you own stock, you should be able to get approved for these types of trades fairly easily. The process is usually only a matter of checking a box or making a phone call to your broker. Then you will be on your way to being the next Bernard Baruch.