Now that we’ve gotten through the basics of options and understand the variables that determine their price movements, here are some more advanced option strategies. There are numerous option strategies, some with colorful names ranging from a Long Strangle and Iron Butterfly (not the band) to fig leafs and Christmas trees. But they all try and take advantage of a scenario or particular trading environment through the buying and selling of calls and puts. Here are four different strategies experienced options traders can utilize to address different opportunities or environments. These include a low interest rate environment, a severe bear market, expected volatility increases or exposure with minimal cash outlay.
Low Interest Rate Environment
Persistently low interest rates present a challenge to many investors because it’s difficult to generate a decent yield from investments. Bank savings rates are under 1%, a U.S. 10-Year Treasury bond pays under than 2% and the yield on the stock market is 2.5%.1 And these are all before taxes.
There are options strategies that can be used to generate income for a portfolio. Since you are looking to generate income, these strategies will typically be achieved by selling (a.k.a. ‘writing’) options so you’re being paid the premium up front-that’s the ‘income’.
One way is with a covered call strategy. Here, an investor writes call options on positions they currently hold in their portfolio. Since you own the underlying stock it’s considered “covered”. If you didn’t own the underlying stock, it’s considered “naked”. You sell the call option (with a strike price typically out-of-the money) and collect the premium as your income. If the stock remains flat or goes lower, you keep the premium and look to do this again. The downside to this strategy is if the stock rockets higher you forego any appreciation above the strike price. Remember, this is foremost an income generating strategy.2
A bear market is commonly defined as a market, or stock, that goes down 20% from its high. In reality, bear markets can be much more severe and can wipe out investors. Here are a couple option strategies that allow you to protect your portfolio’s holdings or even make money in a bear market.
Say you own 100 shares of Apple stock but you’re nervous the stock could collapse over the next few months is an unfavorable ruling comes out regarding the FBI encryption case. You don’t want to sell your Apple stock because 1- you don’t want to give up the dividend you’re receiving 2- you bought the stock years ago and have accumulated large capital gains (which you don’t want to pay taxes on now) and 3- you are a big fan of the company and love their products. You can protect, or hedge, your Apple position by purchasing one Apple put option expiring in three months (the time period you’re nervous about) costing $5 per contract. Since one contract represents 100 shares, that’s all you need to buy to hedge your 100 share position. This $500 outlay protects your position over this period of time.
If the ruling is negative for AAPL you could sell the option for a profit, offsetting (roughly) the loss on your underlying stock position. If the ruling was positive or neutral for Apple and the shares stayed the same or went higher over the time period, the put option would expire and you’d lose the $500 premium you paid for the put option. Consider it insurance-you pay for it even though you may not always need it.3 In the case of 2000 and 2008, many investors wish they had some portfolio insurance that protective puts could provide.
A more aggressive bearish strategy is naked call-writing. By writing call options, you predict the market, or an individual stock, will be considerably lower over a certain time period. You’d pocket the premium received for writing the call option because the option would expire worthless (under your scenario). Another benefit of this strategy is as the market persists lower, implied volatility typically increases, so you’re capturing richer premiums if you continued to sell options.
But similar to short selling, selling naked calls can be a risky strategy and is often flagged by brokers as too dangerous. Some even disallow this strategy in retirement accounts because if you’re wrong, the losses are theoretically unlimited.4 Say the stock you bet against flies higher, perhaps getting bought out by a competitor. The call option you sold becomes deep in-the-money so you’ll probably be obligated to sell the stock to the call option owner. Since you don’t own the underlying stock to sell to them, you’d have to go out into the open market and buy the stock (at an astronomically high price) and sell it back to the call owner (to satisfy the contract) at the much lower strike price. This would result in a large loss.
Staying with the Apple example, an investor has been following the news with regards to the FBI’s case against Apple regarding the unlocking of the phone’s encryption. Let’s say the case has finally made it to the Supreme Court and a decision is coming by the end of the week. You expect there will be a huge move in Apple’s price one way or the other, based on the decision. If the courts rule in Apple’s favor you expect the stock to jump. But if they rule with the FBI which could harm Apple’s sales and image, you expect the stock to crater. In other words, you expect heightened volatility, you just don’t know which direction. This scenario is tailor made for a long straddle option strategy. It’s called a straddle because you are “straddling” the fence, not sure which way it will go.
In this strategy, the investor would simultaneously purchase both an at-the-money Apple call and put option. The premise is that one of these options will quickly move in-the-money after the announcement, while the other one will be quickly out-of-the money and probably expire worthless. The hope is that the gain from the extreme move in one of the options, plus an increase in volatility, will more than compensate for the loss in the other option. Since you’ll be buying two options, you should look to buy when implied volatility is low, so you don’t overpay.5
Minimal Capital Outlay
Another advantage of using options is that you can gain equity exposure with significantly less capital outlay.
Buy it Cheaper with Naked Puts
An investor can lower acquisition costs with a naked put strategy. Let’s say you’re looking to buy 100 shares of Apple, but only if it gets cheaper. Assume Apple is trading at $105 but you only want to buy it for $95. You see a put option on Apple expiring in three months with a strike price of $95 for $2, so you write it-pocketing the $200 premium. If Apple’s stock goes higher, the put option will expire and you’ll simply keep the premium. You can afford to be patient. If something negative happens to Apple’s stock before expiration and the put option gets exercised by the buyer, you are obligated to buy the stock at $95, which you’re OK with. So instead of paying the original $105 for AAPL shares, you’ve effectively purchased the shares for $93 (the $95 you’re obligated to buy it at via the option contract, less the $2 premium you received when you sold the call option).
If you want to take the limited cash outlay a step further, you can actually create a synthetic stock with very minimal capital deployed. In this strategy, the risk/reward profile is the same as purchasing the stock outright, but only over the time period covered by the options.6 This is a short-to-intermediate term strategy.
The strategy involves two options transactions: buying a call option and simultaneously writing a put option on the same stock, with the same strike price and expiration. You can think of a synthetic stock as a long futures position on the stock.
If the underlying stock goes up, your call option goes up in value and you pocket the premium received when you wrote the put option (which should expire worthless). Here, you’ve gained upside exposure to the underlying stock for a fraction of what it would cost to purchase the underlying stock. Your outlay is just the price of the call option less the premium received for the put option. If the stock goes down, you would experience a loss similar to you owning the stock. The call option would expire worthless but would be offset somewhat by the premium you received for writing the put.
As you can see, with a little creativity and background knowledge, the use of options can provide an investor with more flexibility. Always consult with a financial advisor before implementing any option strategy as they may not be compatible with your individual risk or tax profile.