Given where we are in the market cycle, there are two simple strategies you can use to protect your stock portfolio while simultaneously allowing for further gains. Normally options are associated with gambling or speculating, as they provide an excellent, albeit very dangerous, vehicle to do so. However, there is an excellent use of options for investors as well, and it may be something you should consider in the current environment.
There are two main types of options. A call option gives the buyer the right, but not the obligation to buy a stock or index at a certain price up until the expiration date, while a put option gives the buyer the right, but not the obligation, to sell a stock or index at a certain price up until the expiration date. The seller of both of these, on the other hand, collects a premium from the buyer. If the buyer does not exercise the option, this is essentially free money. However, if the buyer exercises the options, the seller is now obligated to make good.
Now let’s say you have a stock portfolio and you would like to be able to take some advantage of any future rises in the market, but you are worried a crash may be coming. You can buy what is called a “protective put,” which is a put option a slightly lower level than the markets currently are. If the option expires in two months, what this means is that you have bought an insurance policy to drastically limit your losses in the event the market crashes. If things keep going up, you throw the option away, keep making money on the rise, and your return is slightly diminished by the price of the option.
Another strategy is called a “covered call,” only this time you are selling an option that gives the buyer the right to buy. This means you will have the obligation to sell if the market rises, locking in a profit, and if the market falls you have received some extra cash to give you a bigger cushion prior to selling out on the downside. I personally would only use this if you already know you want to exit your position and go into cash, but would like to squeeze a little profit out of the investment.
Different factors will affect the price of the options you use to implement these strategies. The longer the time until expiration, the more you have to pay for the option. How far in or out of the money an option is will also determine its value. In the money means the exercise price already represents a profit based on current market levels. A call option with an exercise price of 10 when the underlying stock is trading at 11 would be “in the money” by one. If the stock was trading at 9 it would be “out of the money” by one.
The thing to remember about both strategies is that there is no such thing as free lunch. The cost of the premium of a protective put or the loss of upside potential in a covered call strategy reduce your overall return. The trade-off is that you are buying a reduction in risk while keeping the upside protection in the first strategy, or generating a little extra cash on a position you wish to exit in the second.
David Mayes MBA provides wealth management services to expatriates throughout Southeast Asia, focusing on UK Pension Transfers. He can be reached at david.m@faramond.com. Faramond UK is regulated by the FCA and provides advice on pensions and taxation.
