Adding Options to Your Portfolio
The mere mention of options can send shivers down the spine of investors who have only heard about them through the news. Many of the ways options are used are given exotic sounding names, like the butterfly spread, and require complex mathematical models to understand. And, to be sure, when used imprudently, options can do a great deal of damage to a portfolio. But, when used prudently, options can be a valuable addition to an investor’s toolbox.
There is one option strategy that is particularly easy to both understand and use, even for the novice options investor: covered calls. For most cover call sellers, the basic idea is simple: sell the right to buy a stock when the expectation is that the call buyer will not want to exercise that right. Hugh?
In simple terms, you may own a stock that you don’t expect to advance materially in the near term. You might believe it will stay flat, rise only modestly, or even fall. When you sell a call on such a stock, presumably at a price that is near or higher than the current value, you are selling to someone the right to purchase that stock from you at the higher price. You get paid for giving them that right. If you are correct and the stock does not advance beyond the price stipulated by the call, you get to keep the price that was paid for the option and the stock (which you presumably want to keep). If you are wrong, and the stock advanced beyond the price stipulated by the call, you may have to sell it at that price. In this case, you get any profits from the sale of the stock (based on your original purchase price) plus the amount received for selling the call.
There is very little risk involved in this type of options trade because you own the stock in question. The worst-case scenario is that you have to sell the stock you own, which potentially limits your upside potential. The best case is that you get to keep the stock and the price of the call you sold. These are the only two outcomes if you don’t close the position prior to the maturity date of the call.
How can this help you? Keeping it simple, it can increase the amount of income you generate with your portfolio. There are some mutual funds, such as Gateway Fund (GATEX), that use this technique (see related article ), as well as some exchange traded funds (e.g., PowerShares S&P 500 BuyWrite Portfolio (PBP)) and closed-end funds (e.g., BlackRock Enhanced Dividend Achievers Trust (BDJ)). You might consider examining these investment options to get a handle on what the managers of the funds are doing and how you could apply their methodologies to your own portfolio. You might even decide to stop there and “outsource” this technique to a professional.
Pairing your portfolio with Value Line’s Options Screener, however, is the easiest way that a subscriber to The Value Line Options Survey can use the covered call technique. There are several ways to do this, but the simplest one is to put the tickers of the stocks in your portfolio into the screener and the screener will provide ranks for several different option trades, including call writing, for every stock ticker you put in. Using this as the starting point, you can evaluate the potential covered call transactions available to you.
Clearly, more homework is needed on using Value Line’s Option Service before you jump in and do a trade, but it’s meant to be pretty simple to understand and apply the System’s recommendations. That said, covered call writing isn’t terribly complicated, so going it alone is a viable “option”, too. In that case, you should consider educating yourself fully on the topic before heading out to call your broker. To that end, Value Line provides a primer on covered calls in our option education section that is quite useful.
Once you are more confident with covered calls, you might find other options strategies of interest. But covered calls are probably the best starting point for adding options to your portfolio.