Options as Tools for Portfolio Management and Risk Reduction – Not Mere Speculation

Given the recent history of options trading, it is clear that the option market is becoming very mainstream. But how many traders are speculating or swing trading in issues using options? And how many have realized the true value in options, as portfolio management tools?

The great and chronic risk in holding a portfolio of long stocks is that markets simply don’t move upward without fail. Even when overall markets go bullish, individual stocks do not always follow. Thus, many theories have arisen: focus on value investments, go for growth stocks, return to the tried-and-true days of buy-and-hold. But with any of these old formulas, one fact remains: owning stock is risky.

Traders who are versed in options trading have come to realize that well-structured strategies can, in fact, mitigate portfolio risk and in some ways eliminate it completely. This is a reference to strategies beyond the protective put or covered call. There are times when the use of strategies may enable you to hold onto shares with all downside risk eliminated.

For example: You own stock that you bought years ago at $22 per share. Today, the price is $36 and you are thinking of taking your profits. However, you continue to believe the price will grow more in the near future. So what do you do?

If you are willing to risk having shares called away, you could execute a covered call. This accomplishes two benefits. It is merely a contingent sale, meaning exercise occurs only if the positions goes ITM (In-The-Money, stock above the strike price of the sold call). If your strike is a 37.50 or a 40, it is OTM (Out-of-The-Money) at the moment. If exercise comes up in a month or less, you stand a fair chance of being able to close the short call at a profit or to hold until it expires worthless. This is not a bad strategy.

However, the downside risk remains. How can you eliminate that risk entirely?

There is a way. Rather than settled for only a covered call that is OTM (like the example above), why not also open a long put as part of a collar or synthetic short stock position? In either case, the premium you get for selling the call funds the cost of buying the long put. This wipes out market risk below the put’s strike, since intrinsic value of the put will grow one point for each point the underlying declines. But what is the value if the overall premium is a breakeven deal? You make no money on the call because it is used to pay for the put. So where is the benefit? There are two cases in which this makes sense.

First is when the call income exceeds the put cost. For example, if you own 600 shares, open six short calls but only three long puts. This protects half of the position against downside price movement, while creating a net overall credit. There are even instances where a one-to-one short call and long put will create a credit, but a much smaller one than if you ratio out the coverage. You accomplish a similar result if you turn the short calls into a variable ratio write (Since this includes the sale of naked call options check with your broker to see if you are qualified to do this); for example, you have 600 shares, so you buy six puts and sell nine calls, six at the next strike above current price and another three at the strike above that.

Second is when you want to hold shares until at least the next schedule ex-dividend date. If the dividend is attractive, continuing to hold shares is a worthy goal. The collar or synthetic short stock strategy enables you to earn the dividend while eliminating downside risk.

These examples are some of the many ways that options can be used to reduce or eliminate market risks in your portfolio. There are many, many more …

Michael C. Thomsett

About this week’s Heavy Hitter: Michael C. Thomsett is a widely published options author. Thomsett blogs at FT Press, Benzinga and Seeking Alpha. His website is www.MichaelThomsett.com Twitter: @ThomsettPublish