We all know about speculating with options, the market risks on the long and short side, and exercise possibilities. But putting all of that aside for the moment, do options serve a more valuable and even a more conservative purpose?
How about managing portfolio risks with options?
Every long position in your portfolio is exposed to market risks and the only way to avoid these risks is to keep your money in your mattress, where the “riskless” idle money gradually loses its purchasing power. In other words, you have to live with risk. This doesn’t mean you have to suffer its consequences, though. Risks can be mitigated and even eliminated with well-selected options strategies.
Of course, the first thing everyone thinks about is the covered call. This is a good way to discount a basis in a long position, but it only gets rid of some of the risks. Many other strategies can be used as well to further enhance the value of your portfolio while avoiding loss.
The insurance put is a great way to give up a small portion of paper profits to fix the loss in the event of a price decline. This is a perfect strategy for appreciated stock, when you are bullish but fearful of a short-term downtrend. The maximum loss is fixed at the net of the put’s strike minus premium you pay for the put. So in a price decline, you offset the loss by selling the put, or you exercise the put and sell shares at the strike. In the event the price continues upward, you have protected the position but did not need to sell shares prematurely.
A collar also protects against downside while also exposing you to the possibility of exercise at a profit. The typical collar is a combination of long stock, traditionally with a lower-strike long put and a higher-strike short call. Because both options are OTM, the net debit will be small (it might even be a credit). If the stock price goes below the put’s strike your benefit is limited risk, as this is a variation of the insurance put. If the price rises above the short call, your stock is assigned. You can avoid this by closing the call or rolling it forward.
Yet another strategy is one called long synthetic stock. This is like a collar, except there is no stock position, and a long call and short put position are opened at the same strike price. This performs best when the stock price rises. The call picks up value while the put expires worthless. If the stock retreats the risk is being assigned on the short put position. A synthetic short stock position combines a long put with a short call, also with no initial stock position. If the price declines, the put gains in value and the call expires worthless. But if the price rises, you could be assigned on the short call. This could be avoided by closing, rolling, or covering the short call. Many brokerage firms require a special approval level for naked short calls.
These examples are but a few of the ways options can be used effectively not as speculative side bets, but as smart portfolio management tools.
Michael C. Thomsett
About this week’s Heavy Hitter
Michael C. Thomsett is a widely published options author, with six options books in print, published by John Wiley & Sons, FT Press, Amacom Books, and Traders Library. He has recently signed a contract with Palgrave Macmillan for a two-book deal, both books on options topics.