Many look at the options world as a high-risk gambling hall, not much different than Las Vegas or Atlantic City. Take your chances on a low percentage outcome where the house has a constant advantage, let the chips fall where they may. I suppose there are some with a huge risk appetite that needs to be fed and in this case the analogy is appropriate. However, I would argue that options can provide a great deal of leverage, protection, timing and produce nice income. For those with limited funds who desire to grow their accounts significantly options trading is a great way to get this done. Further, those who are looking for additional sources of income for their portfolios can take advantage of time and volatility.
One of the strategies I use in managed accounts is option selling or premium capture. As options are a zero sum game, I am simply selling an option to a buyer, both of us awaiting the outcome at expiration. For example, As a call seller I will take in the premium from the buyer with the hope the stock will stay where it is (if at/below the strike) or drop. The premium erodes but I have already pocketed the premium, and if I ride this to expiration the option goes out worthless – nothing further to be done.
Contrarily, if the stock rises past the strike I am on the hook for the difference between the price and the strike including the premium already collected (which can be substantial or unlimited in the case of selling naked calls). So, there is risk but as a seller I have a great advantage, which is that 75-80% of all options expire worthless every month. How about those odds if you’re a seller? Further, an options trading premium seller can increase their odds by selling out of the money options. In addition, a seller can cut down risk and increase their odds by purchasing a lower strike (creating a spread, something I do often), while the return is lower the losses are capped.
Say you have a long portfolio of stocks, some of which are paying a nice dividend but others are not. For instance, you have some high beta names like Google, Priceline or Apple which are great for growth but are not providing you with strong regular income. This is where an options trading enhancement works best, a covered-call strategy. Simply put you write (sell) a call against your stock, take in the premium and wait. The risk here is the stock rising past the strike you sell (normally you would go with a strike above the stock price on a high beta name so as to participate in some more upside) and your gains are capped to the strike plus the premium you collected. But, we said earlier that 75-80% of all options expire worthless, right?
The odds are in your favor if you ride it out to expiration. But if you do get your stock called away – it can happen – then you can just buy it back, and sell a call again. Many out there trade options for income and write calls against their stock month after month and generate what I call an ‘extra dividend’. The annual return on this strategy is a substantial enhancement to the performance of the portfolio.
Part 2 later in the week will talk about using options to protect your portfolio, getting put stock at a lower price and identifying the best and worst times to sell options.