Using Options to Enhance Returns
Written by Eduardo Pinheiro   
Sunday, 15 November 2009 00:00


Options can be a valuable instrument for enhancing an investor's returns. Option investing must be done strategically or the risks and costs outweigh the benefits.

The two strategies are like are the simplest ones: covered call and put-write.

Covered Call

A covered call strategy is when an investor sells a call option, giving the buyer the right to buy the stock at a given price in the future, while holding the underlying stock. This strategy has the disadvantage of limiting the upside for the option seller, but provides current income.

I've used this strategy recently when volatility was high. I bought the Dow Jones Industrial Index ETF (DIA) for $85 back in January and sold call options expiring in March for a strike price of $86. In March, of course, the entire market dropped, so the call options expired worthless and I got to keep the $2.5 premium I was paid for the options.

I then replayed this strategy a few more times and eventually the call option expired in-the-money, at which point my DIA shares were called and I was paid $1 above what I had paid for each share, and still got to keep the premium. But I forfeited a few extra bucks the stock had appreciated when the options expired.

Put Write

Puts give the option buyer the right to sell a stock to the put seller in the future for a given price. I use put write when I want buy a stock for a price lower than the current one being offered by the market. In this strategy,  I typically sell out-of-the-money puts that are covered by cash. If the stock drops, I get to keep the premium and I get the stock for the price I established.

The downside is that if the stock drops even more, I'll be buying it for the strike price, which could be a lot higher than what the stock is trading for at the time of option expiration.

I've recently used put write to buy the DIA ETF I mentioned above for $85 back in January. I sold at-the-money January put options and a few days later I was assigned the ETFs for $85, and I still kept the $1.36 premium I was paid for the options.

I've also used put write to try to acquire shares of V and MA at lower prices. In both cases, the options expired worthless and I did not get the shares. But I still got to keep the premium.

Current Opportunities

With the market currently going up (mostly due to devaluation of the dollar, I speculate) I don't think selling covered calls is a good idea, as my shares could be called and I currently don't have temporary or speculatory positions.

On the put write side, currently I don't have many great ideas either because my entry prices for stocks are way below their market prices right now. But for someone willing to enter the dividend investing strategy, selling at-the-money puts on the Dividend Aristocrat Index ETF (SDY) is not a bad idea. One can get $0.45 for the November $45 puts or $1.45 for the December puts. SDY is currently at $45.50, so a slight drop and a premium on the puts could help one get started on a solid selection of dividend payers.

Summary

The bottom line is that there's money to be made with options. However, there are risks both in terms of loss and limiting upside. One should use options to enhance returns only when one can afford to lose in the worst case scenario.

It's important to note also that options are a zero-sum game: one investor wins at the expense of a loser on the other side. So, unless one has a clear advantage, odds are one'll be the loser just as often as the winner, or possibly more often, given that there are smart players with lots of resources and lower costs in this game.

Disclosures: Long V.


read full article


blog comments powered by Disqus

Share this post

Last Updated on Sunday, 20 June 2010 06:36
 

Subscribe by email

Enter your email address: