Options can be a very useful tool to boost your portfolio's returns. While options can be very risky when used to speculate, this isn't necessarily the case when using options backed by stocks you would like to own or which you already own.
Value investors looking for increased returns to their portfolios can employ two options strategies. One is selling covered calls, and the other is selling naked puts.
Being "covered" means that you already own the asset needed to fulfill the obligation of the call option if exercised. Your downside is limited as a result. A "call" means that the purchaser of the contract has the right to purchase the stocks specified from the seller at the exercise price (upon expiry if the market price is at or above the exercise price).
As a value investor you want to hold onto your investments until they approach your estimate of the intrinsic value. Depending on the situation this can take from a few months to a few years. By selling covered calls at your estimate of intrinsic value you receive the premium from the contracts and only need to sell the actual stocks if they reach their fair value by expiry. If this doesn't happen you can employ the process repeatedly, generating a steady stream of premiums.
A "naked" option means that you are left exposed to unknown downside risk in the event that the option is exercised. A "put" means that the purchaser of the contract has the right to sell the stocks specified to the seller at the exercise price (upon expiry if the market price is at or below the exercise price).
By selling naked puts, the value investor is committing himself to purchase a security only if the market price at expiry is at or below the exercise price of the contract. If a security that you would like to own is currently trading at too high of a price then by selling naked puts you essentially earn a premium today and only need to purchase the stock if it reaches your entry price or below by expiry.
As shown above, the contract sold for a covered call should have an exercise price equal to or slightly below your estimate of intrinsic value and the exercise price of a naked put should be equal to your desired entry price. The last decision is the time until expiry, which is a personal choice. The longer the option has until expiry the more valuable it will be, but it also exposes the seller to the risk that something material may change within the company during this time. If a material event impacts your estimate of intrinsic value then you may be contracted to sell or purchase stocks at prices you no longer want to. As a general rule, puts can be sold for a long time out if you believe the company to be stable with changes to intrinsic value (on the downside) being unlikely. Selling calls far into the future however may cause you to hold onto a security well passed the time it reaches intrinsic value, perhaps causing you to miss a window of opportunity to sell if market fluctuations bring the price back down.
The risk involved in these strategies is that you may be either a) forced to purchase a stock for more than the market price (in the case of a put) or b) forced to sell a stock for less than it is currently trading in the market (in the case of a call). Either way, if you are confident in the intrinsic value you determined for the company then you are no worse off than if you didn't sell options but rather purchased and sold the stocks according to your stringent entry and exit points. In fact you are better off, because with options you've earned the premiums.
Jonathan Goldberg
http://www.jonathangoldberg.com/
Value investors looking for increased returns to their portfolios can employ two options strategies. One is selling covered calls, and the other is selling naked puts.
Being "covered" means that you already own the asset needed to fulfill the obligation of the call option if exercised. Your downside is limited as a result. A "call" means that the purchaser of the contract has the right to purchase the stocks specified from the seller at the exercise price (upon expiry if the market price is at or above the exercise price).
As a value investor you want to hold onto your investments until they approach your estimate of the intrinsic value. Depending on the situation this can take from a few months to a few years. By selling covered calls at your estimate of intrinsic value you receive the premium from the contracts and only need to sell the actual stocks if they reach their fair value by expiry. If this doesn't happen you can employ the process repeatedly, generating a steady stream of premiums.
A "naked" option means that you are left exposed to unknown downside risk in the event that the option is exercised. A "put" means that the purchaser of the contract has the right to sell the stocks specified to the seller at the exercise price (upon expiry if the market price is at or below the exercise price).
By selling naked puts, the value investor is committing himself to purchase a security only if the market price at expiry is at or below the exercise price of the contract. If a security that you would like to own is currently trading at too high of a price then by selling naked puts you essentially earn a premium today and only need to purchase the stock if it reaches your entry price or below by expiry.
As shown above, the contract sold for a covered call should have an exercise price equal to or slightly below your estimate of intrinsic value and the exercise price of a naked put should be equal to your desired entry price. The last decision is the time until expiry, which is a personal choice. The longer the option has until expiry the more valuable it will be, but it also exposes the seller to the risk that something material may change within the company during this time. If a material event impacts your estimate of intrinsic value then you may be contracted to sell or purchase stocks at prices you no longer want to. As a general rule, puts can be sold for a long time out if you believe the company to be stable with changes to intrinsic value (on the downside) being unlikely. Selling calls far into the future however may cause you to hold onto a security well passed the time it reaches intrinsic value, perhaps causing you to miss a window of opportunity to sell if market fluctuations bring the price back down.
The risk involved in these strategies is that you may be either a) forced to purchase a stock for more than the market price (in the case of a put) or b) forced to sell a stock for less than it is currently trading in the market (in the case of a call). Either way, if you are confident in the intrinsic value you determined for the company then you are no worse off than if you didn't sell options but rather purchased and sold the stocks according to your stringent entry and exit points. In fact you are better off, because with options you've earned the premiums.
Jonathan Goldberg
http://www.jonathangoldberg.com/
