Lower Risks and Boost Returns With Options
Trading options can be risky, but they can also be used to manage risk while also boosting returns. I use options to buy stocks at a discount and to earn a small premium when selling them.
Over the course of my next two articles, I will review this approach, using real-life examples from my own portfolio.
Options Case Study: Apple
An investor can buy or sell call options or put options.
A call option represents the right to purchase shares of an asset at a particular price within a specific time period.
For example, Apple (NSDQ: AAPL) shares closed last Friday at $174.97. If I believe Apple shares will soar, I could buy one call option that would allow me to purchase 100 shares of Apple in the future.
For example, I could currently pay $6.35 per share for the option of purchasing 100 shares of Apple at $180 a share on or before June 21, 2019 (110 days from now).
That option would cost a total of $635 for 100 shares, and could be exercised by me at any time until the stock market close on June 21. To win this trade, Apple shares need to trade above $186.35 prior to expiration (to recoup the purchase price and the premium I paid).
If shares never trade above $180 prior to expiration, I will lose the premium I paid. For instance, if shares are $175 at expiration, I won’t execute an option to purchase them for $180. But as long as I exercise at a price above $180, I will get part of my premium back, and if I exercise at or above $186.35, I will buy shares for $180 and also recoup my $6.35 premium.
On the other side of the trade is the person selling the option. If I own 100 shares of Apple, and I wish to exit that position at somewhere higher than the current price, I can sell a call option that allows the purchaser the right to acquire those shares at $180.
That means I am conceding a maximum price of $180 for my shares, but I am getting $6.35 per share for that concession. So, if someone exercises that option and buys my shares for $180, I actually get a total of $186.35, which is 6.5% above the most recent closing price. For comparison, if I simply put in a limit order to sell my shares for $180, then I only earn 2.9% above the most recent closing price.
Use of the call option by the seller (a covered call) allows the seller to boost their returns when selling the asset. The downside is that if shares go much higher, they forego those gains for the certainty of the premium.
The Put Option
The put option gives the buyer the right to sell their asset at a particular price within a specific time period. Using the same example of Apple, I could buy a put that expires on June 21, 2019 that would allow me to sell shares of Apple for $180 a share.
At the most recent close, I would pay $11.00 a share for buying this put. I might do such a trade if I wanted to preserve profits and additional upside, but was concerned about the possibility of a sharp drop in the share price.
Now, assume for a second that I don’t own shares of Apple, but I wish to acquire 100 shares. I wish to pick them up at a discount to the current price. So, I sell the above put (a naked put), receiving $11.00 a share in the process.
If Apple trades below $180 a share prior to expiration, the purchaser can exercise the option and force me to buy their shares. But my net price for the shares is $180 minus the $11 premium I received. Instead of paying the current price of $174.97, the shares actually only cost me $169.
The risk here is that if the price plummets for some reason, you may end up paying $169 for shares that are now worth $150. That happens all the time, but keep in mind that you are still nearly $6 a share better off than if you had simply bought shares at the market price.
I actually used the example of Apple for a reason. I have been in and out of Apple over the years, including multiple trades in 2018 similar to those described above.
In next week’s article I will provide an example of how I recently used this strategy to lower my cost basis for Apple shares I recently acquired by over $17 a share, and how I can make $25 a share while buying and selling shares at the same price. These strategies come in handy, as the overall market faces mounting risks.
Are you looking to profit in up or down markets, regardless of mounting risks? My colleague Amber Hestla has figured out a way.
Amber Hestla is chief strategist of the investment advisory Income Trader. She’s an ex-military intelligence officer who has spent her career sifting through white noise to pinpoint the facts that really matter. She has deployed her war-fighting skills to create a money-making system.
Amber Hestla’s strategy can help you make money every time you trade. Her track record is well-documented and speaks for itself. Click here for all the details.