Market Beat: Investors need to study, understand options before use
Options are contracts that can be used with stocks, exchange traded funds, indexes and futures. They are a type of derivative because their price is mathematically derived from the price of something else, which is the underlying security. Options are not suitable for all investors, and it is critical to thoroughly understand how they work before using them.
There are two types of options, calls and puts. If you own a call option you have the right but not the obligation to buy the underlying at a set price known as the strike by a certain time, which is the expiration date of the option contract.
Conversely, owners of put options have the same right to sell the underlying. If you decide to sell options you’ll be obligated to fulfill your end of the contract by either buying or selling the underlying.
Selling call options against one of your holdings is known as a covered call and is one of the most popular option strategies.
The way is works is pretty simple. For example, if you purchase XYZ stock at $25 per share and you’re willing to sell it for $30, you could sell a $30 strike call option for $1. If XYZ is below $30 at expiration you will still own the stock and keep the $1 earned in premium.
If it’s above $30, you sell at $30 plus the $1 premium for a total of $31. Academic studies have been done that show that covered call writing can enhance returns and lower volatility.
Last week, the Fed announced that they are going to begin a process of quantitative tightening, which should lead to higher interest rates.
One strategy that works better with normal interest rates consists of purchasing U.S. Treasury bonds, and then using the interest earned from the bond to buy call options on the S&P 500 index. For example, at today’s rates, if you were to purchase $100,000 worth of 10-year US Treasury bonds you’d have about $2,200 per year to buy call options on the S&P 500 index.
That way you can participate in the upside of the stock market, but the worst case is that you lose the interest earned from the Treasury bonds and your principal is guaranteed by the full faith and credit of the U.S. government. If rates normalize, you’ll have about twice as much to purchase the options with.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.