This is a guest post by Ciaran McKeever and he is a Certified Financial Planner that runs the Chance Favors blog. Chance Favors hopes to educate, encourage and empower those in their 30′s and 40′s to achieve financial independence.
If you’ve been following the stock market then you know the last 2-3 months have been very rough.
There have been days where the DJIA is up several hundred points and days where it’s down several hundred points. Unfortunately (for most investors) there have been far more down days as of late, as the market is off more than 20% from its recent highs.
With that in mind, I’d like to talk to 3 simple option strategies that can be incorporated into your overall investment strategy, to help cushion some of the blows this topsy turvy market is throwing at you.
Now I know some of you will be unfamiliar with equity (stock) options, so I’m going to do my best to keep it fairly straightforward and readable. Even if you don’t understand every last detail, I think you will be able to grasp some of the concepts and see the effectiveness of using options.
Big Fan of ETF’s
If you read my blog (and maybe there are a few of you here, I hope) then you know I’m a huge advocate of ETF’s. One of the reasons I love ETF’s is because you get the instant diversification that comes with investing in an index, and at the same time, maintain some of the positive characteristics that come with owning an individual stock.
One of those positive characteristics is the ability to use basic option strategies to augment your portfolio returns, something you are unable to accomplish with mutual funds or separately managed accounts.
(Everything I am about the illustrate is possible with many ETF’s and most individual stocks.)
3 basic (yet effective) option strategies you should know about:
Selling (or writing) covered calls - earlier on in this post I included a link to the definition of an option, if you have no idea what an option is please read that before preceding any further.
Let’s assume part of the large cap equity exposure in your portfolio is made up of DIA (which is the ETF that tracks the Dow Jones Industrial Average). By selling a covered call versus the underlying DIA (which I will assume you’re committed to holding for the long term) you can take in (realistically) anywhere from 1%-5% in additional income, depending on how aggressive you want to be.
When talking to clients, I often refer to option income as an ‘artificial dividend’, on top of the natural dividend that the position pays out. In volatile markets like these (where the general direction is uncertain) it may pay to take in a few extra percent in income. In essence, you’re getting paid for your time.
Buying Puts in an IRA account - The purpose of an IRA account is to build a nestegg for retirement. For this reason, the powers that be, will not allow you to speculate (or gamble) using certain aggressive option strategies, but they will allow you to play defense (hedge your bets) to protect what you have in there. In an IRA account you are allowed to write covered calls (discussed above) and buy puts (discussed here).
A real example to illustrate the point
Although I strongly recommend clients build portfolios using ETF’s, I have a few clients that make their own unsolicited decisions from time to time. One client in particular, that makes many of his own decisions, has a large IRA account where one of his positions was GOOG (Google).
Since he’s owned GOOG for many years he’s seen significant gains and knows there is a long way down if something bad happens. In order to protect these gains he often bought Puts versus the underlying position.
By doing so he limits the amount he can lose. In this case, when GOOG was trading north of $700 a share, he bought the GOOG 650 Puts which put a floor in place for this position. Since he owned the Puts, when GOOG recently traded way below $650 a share, he lost no further money once it hit $650. The drop in his underlying position was offset by the gain in the GOOG option he purchased (once the stock went below $650.)
I used this dramatic example to drive the point home. Buying puts in an IRA account (versus your underlying positions, especially if they are concentrated) may be an effective way to hedge your positions and lock in recent gains, especially if you think the markets are ahead of themselves, much like they were in the second part of last year.
A financial plan gives you perspective
Buying Puts works well in the context of a financial plan, as well. If you’ve exceeded your relative performance goals then it may be a smart idea to institute a safety net to avoid giving everything back. Unfortunately, you’re not aware of many of these facts if you’ve not completed a financial plan (a discussion for another day.)
Selling (or writing) uncovered Puts - although the most risky of the three strategies, this strategy can be used effectively under optimal conditions. One of the things I’ve heard most over the last three weeks, besides, ‘I’m losing so much money!’ is ‘ I wish I had money to invest right now.’ Well some people do.
And the way many long term investors approach this market is by nibbling (buying) on positions that they are comfortable owning over the long term. Let’s talk in terms of ETF’s, lets say you want to use the recent market volatility to buy more exposure to the Russell 2000 Index (IWM) or the EAFE Index (EFA).
Instead of just diving in, you decide to set certain limit orders below where the ETF is currently trading, at levels you know you’d be comfortable owning more of the ETF. Well, there’s a good chance those orders will never be filled. If the ETF never trades down to those levels, your order will eventually just expire unfilled.
A viable alternative
If you sell an uncovered Put instead, you are setting the same limit orders (as described above), the only difference is you’re being paid for your time (once again). In this case, if the ETF never reaches the level you set, well, then you are paid a premium for your time. If the ETF does trade through your order level, then you have to buy the shares (at that price) which you were committed to doing in the first place.
(Please be aware I wouldn’t have presented this third strategy if we talking about an individual stock. Selling Puts on a diversified ETF is far less risky then selling an ETF on an individual stock. In point #3, I am talking to ETF’s only!)
I think options are somewhat misunderstood. Certain option strategies can be used very effectively in volatile markets, as you wait to see how everything is going to play out. Part of the frustration for many investors (with these kind of markets) is waiting out the storm and getting paid nothing for your time.
If used selectively (and if the situation is right) options can help alleviate that stress. Instead of having your hands tied, there a few things you can think about doing.
I hope this post helps you to recognize that you do have choices, even in these kind of choppy market conditions:)
Disclaimer – this is very important!
There is a tremendous amount of risk associated with many option strategies, much less so with the strategies I’ve introduced, but nonetheless, there are risks. And I can’t stress this enough… speak with your financial advisor or do your own due diligence before acting on anything I’ve written.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.