5 Great Reasons Why You Should Be Selling Options in Your Investment Portfolio

5 Great Reasons Why You Should Be Selling Options in Your Investment Portfolio

You’ve had many successful years trading stocks, but you want more leverage – you want better performance. As you assess strategies to improve your portfolio’s performance, consider an options selling strategy.   This strategy may provide smaller drawdowns and higher realized returns over long time horizons than investing only in equities.

Whether your general outlook is bullish or bearish, there’s a money-making strategy available using options selling. It doesn’t even matter if you’re an aggressive speculative small-cap type of investor, or a conservative dividend paying blue chip investor, there’s a place for selling Puts and Calls that fits neatly within your risk profile.

Here are 5 great reasons why you should include selling Puts and Calls in your portfolio:

#1 – Adds Extra Income

If you could add a few percentage points of additional gains every year while only risking a fraction of the cost necessary to do so, why wouldn’t you do it? Well that’s exactly what happens when you start selling options as part of your investment strategy.

Let’s break down selling a basic Put to show how this works:

  1. XYZ stock is trading at $30 and you think the stock will probably stay at the same price for the next 3 months or so.
  2. You sell a Put on XYZ stock with a strike price of $25 that expires in 3 months for $100.
  3. The $100 is an immediate gain that you pocket no matter what the stock does.
  4. After 3 months, the stock trended slightly lower to $27, but still above your strike price. The Put expires worthless and you realize a gain of $100.

Of course the obvious question is what would’ve happened if the stock fell below $25 and the Put was exercised? You would be on the line to purchase 100 shares of XYZ at $25, but it doesn’t affect the $100 gain you had when you sold the Put. That brings up another great benefit of selling options, but we’ll get to that later.

Over time, seemingly small gains like $100 really add up. It works the same way with selling Covered Calls as well. If you own 100 shares (or more) of a stock already and you don’t expect it to skyrocket anytime soon, you can sell a Call against the stock for a quick profit.

Let’s take a look at XYZ again, this time for a Covered Call. If you bought XYZ at $25, you would’ve paid $2,500 total for 100 shares (minus broker fees and expenses). To give your portfolio another income source, you decide to sell a 3 month Call at $30 for $100. If the price after a few months rises to $27 and you decided to sell, you would have a gain of $200 ($2,700 – $2,500) plus the $100 from selling the Call. That improves your gain from what would have been 8% to 12%. Not too shabby.

#2 – Hedging Your Bets

Arguably the most common thought investors have when discussing selling options is how it can be used to hedge your position. It’s tough fronting thousands (or millions) of dollars to buy a stock that you think is going to explode without protecting yourself against the unknown. You may not think a XYZ has much downside risk until you wake up one morning to discover that new Chinese data reveals a soft market for XYZ’s products that no one saw coming.

One of the simplest benefits to overlook, selling options against stocks that you own helps to lower your cost basis. In other words, it lowers your breakeven point so that a stock doesn’t have to rise as much as it would have had to otherwise if you hadn’t sold a Put or Call. Confused? Let’s revisit our first scenario with selling a Put.

In that scenario, we sold a Put on XYZ with a strike price of $25 that expired in 3 months for $100. Say the price dropped to $23 and you were forced to buy 100 shares for a total cost of $2,500. That means you’re already $200 in the negative right? Not quite. Remember to add back the $100 you received from selling the Put. That puts your cost basis at $24, or $2,400 meaning that you only need to make up $100 to break even.

Whether it’s a Call or Put that you sell, figuring out your cost basis is as simple as adding back the premium you received to get your new break-even number. Over time, you can build up a remarkably low break-even point by continuously selling new Calls as the old ones expire.

So in the above example, let’s say you get assigned 100 shares at $25 and now the stock is trading at $23.  If you sell a 3 month call at $30 for $100, that further reduces your “buying average” of your stock purchase to $23.  If the stock trends up over the next few months to $28, then your actual gain is $500 instead of only $300 if you had just bought the stock at $25 OR worse yet, a $200 loss if you bought the stock originally at $30.  If the stock instead happens to trend down, then your loss would also be less since you pocket all the extra premium from selling an option against your position.  A perfect win-win by hedging your position with options.

#3 – Adds Leverage

Wouldn’t it be nice if you could ratchet up leverage in your portfolio without taking on an equal amount of risk? By selling options, you can do just that. We discussed the downside protection options selling offers, but what about the upside potential?

Instead of simply buying 100 shares of a stock, you can engage in options-only strategies that can result in gains of much higher percentages. Whether you have a bullish or bearish take on a stock, you can use a mixture of options buying and selling to construct a potentially profitable investment vehicle.

For investors eyeing upside potential, a Bull Spread uses both Call buying and selling to maximize gains. An investor simply purchases a Call and sells a Call at a higher strike price. Let’s show another example to illustrate how this works. For emphasis, we’ll use Apple (AAPL) as our stock because of its relatively high price.

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As you can see, to buy 100 shares of this stock would cost us approximately $52,494 – not exactly cheap for the everyday investor. Instead, we’ll use a Bull Spread to invest.

  1. We’re going to buy a July Call with a strike price of $525 for a much more manageable $2,000 and sell a July Call with a strike price of $550 for $1,000 for a total outlay of just $1,000.
  2. Let’s assume AAPL rises much faster than we expected and we get called out of our option and sell at $550.
  3. The difference of $25 equates to a gain of $2,500 giving us a profit of 250%!

If we had just bought the stock and sold it at $550, we would have only seen a gain of 5% — still the same dollar amount, but a huge difference in how much money was initially invested. Of course by owning the stock versus dealing with options we would have been able to hold it longer and take advantage of any gains beyond $550, but the percentage gain would still have been far less.

For bearish investors, you can use a Bear Spread — essentially the same thing, just done with Puts rather than Calls. You would have bought a Put and sold a Put with a lower strike price instead of a higher one.

#4 – Gives You More Flexibility with Price Movements

Face it, no matter how good you are, you can’t predict the future. You’ve probably encountered a situation where you found a stock that you like, but weren’t completely satisfied with its short term outlook so you stayed away only to watch it take off. Or perhaps you waited for the price to drop to a level you liked only to wait around for several months while your money stagnated until you bought. Selling options is the answer to those issues. It removes the need to “time” a stock, which can be quite stressful for some investors.

If you’re interested in a stock but don’t think it will make a strong move higher for the next quarter or two, don’t hesitate to buy because you might miss out on possible gains elsewhere. You can supplement your income by selling Covered Calls and cash in on some short term gains while you wait for the catalyst to emerge. If it’s a dividend stock, you win on two fronts as well.

For a stock you like, but aren’t convinced you should buy it at that price, why not sell a Put instead? If the stock never drops, then at least you made a few bucks on the idea and if it does drop, then you get to buy it at the exact price you wanted, plus you keep the premium from selling it. It’s as close to a win-win scenario as you can find in the stock market.

#5 – Lets You Trade Flat Markets

Investing in a rising or falling market can be a no-brainer, but when a market starts trading sideways, it can leave many would-be investors scratching their heads on the sidelines wondering when they should jump in. The barren landscape can lull you into apathy and leave your money sitting high and dry. Flat markets don’t have to be a time of financial drought for your portfolio; there are several strategies that can help you turn a profit.

Don’t just resort to investing in high-yield dividend stocks to make your portfolio profitable, this is where options selling really shines! If the majority of stocks are trading flat, then Covered Calls can be a viable solution for virtually everything in your portfolio. Think of it as turning every stock you own into a dividend paying one. You might not get stratospheric gains out of it, but you can tell all your friends how you made 12% in a year when most people saw 3%.

Selling Puts operates in much the same manner. As volatility decreases, selling Puts becomes a much less risky venture. The threat of being forced to buy is much lower, although you should still only use this strategy on stocks that you would actually consider owning anyways. Keep in mind though, with less volatility come cheaper premiums which take a bite out of profitability.  However, on the other side of the equation, when volatility increases not only does the put premium increase you’ll also be able to go further out of the money with your put selling and acquire stocks at a much bigger discount than you would normally have by buying stocks directly.

Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions on the companies mentioned through stocks, options or other securities.

 

 

 

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