Market Beat: Options strategies for stock investors
Options are tools that stock investors can use to help manage their investment portfolios. Using options requires quite a bit of sophistication and they are certainly not suitable for all investors.
There are two types of options: puts and calls, and they can be combined in a variety of ways to produce different outcomes. If you own a put, that gives you the right but not the obligation to sell your stock or ETF at a set price by a certain date. Conversely, if you own a call option that gives the owner of the option the right but not the obligation to buy a stock or fund.
One of the most popular options strategies is known as the covered call. The covered-call strategy consists of buying a stock or fund, then selling a call option. When you sell a call option you become obligated to sell your underlying stock at a set price by a certain date. In exchange for being willing to sell the stock you receive a payment known as a premium. What you do is purchase the stock and then decide a higher price that you’re willing to sell at a set date in the future. The premium that you receive is yours to keep.
The premium you are paid also provides a little bit of downside protection. One disadvantage to the covered-call strategy is that in exchange for receiving the premium you limit your upside potential.
For example, say you buy ABC stock for $100 per share and are willing to limit your upside to a 12 percent annual return, you could sell a one year ABC $110 call for $2. If ABC was called away from you at the expiration date you’d get $110 for the stock plus the $2 option premium for a 12 percent return. If ABC was below $110 at the option expiration, you’d keep the stock plus the $2 call premium. In the event that ABC paid a dividend, the investor would collect the dividend income as well.
So, if the dividend yield on ABC stock was 4 percent, now the total return for the best case scenario would be 16 percent, after you add in the dividend yield.
Writing call options on dividend paying stocks or exchange traded funds can be a good income producing strategy for fairly sophisticated investors.
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.