Money Management & Retirement Planning Advice by Barry Unterbrink, Chartered Retirement Planning Counselor

Wednesday, September 09, 2009

Options for Your Investing Benefit

Using Options to Enhance Your Portfolio

Understanding exchange-traded options can increase your financial returns and reduce risk in your investment portfolio. Stock options are an excellent way to help you achieve your money goals, both before and in retirement. Today we will look at using stock options to enhance your stock market profits, so get a sharp pencil and pad and follow along.

You probably already understand the basic option concept. If you were selling your car, and the buyer really wanted the car, but needed some time to raise the money, you may recommend an option. For a $50 payment from the buyer, you could grant the buyer 48 hours to raise the money to buy your car for $2,000. You are obligated to not sell the car to anyone else before that time. You are the seller of the option. The buyer of the option has the RIGHT, but not the obligation, to BUY your car for $2,000 in the next 2 days, or he may walk away from the deal, thus losing his $50. This arrangement places some risk on both parties - the buyer will lose $50 if he does not buy your car, but he has 'bought' himself some time with his option, to buy the car at a pre-set price. The seller gets to keep the option "premium" of $50, but is prevented from selling the car to anyone else for two days (another buyer may offer $2,400 and he has to reject that offer, and all others during the two day time period). Okay, let's discuss how options work when buying and selling stocks.

Basically, stock options work in a similar way, and your involvement with buyers and sellers is handled seamlessly by the options exchange. The options exchanges settle all the money and stock amounts for you through your brokerage or investment account. With options, your goals will dictate which type of strategy you should employ. In its simplified form for this discussion here, the two types of options are CALLS or PUTS. A call is a right by the owner to BUY a stock at a preset price within a certain time frame; a put is an option by the owner to sell at a certain price and time. Let's run through an example using recent real world prices for a CALL option strategy. You buy 1,000 shares of Bank of America stock for $16.00 last month. You are favorable on the company, hoping that they continue to execute their strategy and climb out of this banking mess. You envision perhaps $20 as a target price early next year. At $17.00 a share now, you are willing to sell your shares at $20 in January, 2010. You could wait for the $20 price and realize a $4 per share gain. Alternatively, you could SELL a January $20 call option on the options exchange, giving someone the RIGHT to buy your shares at $20. Remember, above I told you the "owner" of a call option can buy at the $20 price, this term is the option exercise price. Since you are the seller, you must deliver 1,000 shares to the buyer any time up 'till the option expiration date. Your sale of the options as a "seller" results in a CREDIT of $120 per option contract ($1,200 credit for 10 contracts, since each option contract covers 100 shares of stock). Now consider you ledger worksheet after your 10 options have been sold ...
1,000 shares of Bank of America stock bought at $16.00 per share = $16,000
> Sold 10 January $20 call options at $120 <1,200>
> Adjusted cost for your 1,000 shares of stock $14,800

Follow me here: If the shares of Bank of America are higher than $20 by the expiration date of the call options on January 15th), the buyer or owner of your call option that you sold will
exercise that option to buy your 1,000 shares at $20. Why? Because he can then immediately sell them for more in the market. By selling the option right, you have capped the amount of gain you can realize on your stock during the 4 month period. That's the trade-off you've agreed to. If BAC is $20 or below, then the option buyer will just walk away and the option will expire
worthless. Zero. He's lost $1,200. You keep his $1,200 either way.

So why do this? It takes two to tango in options, buyer and seller. By lowering your cost from $16.00 to $14.80 by selling the options, you have added some additional profit into your ownership of BAC shares - about 7% more in 4 months. You get to keep your 1,000 shares if they are under $20, and can then sell them or employ another strategy. Suppose BAC shares do not move above $20 for the next 6 months after Jan,15-2010? ... you could keep the shares and sell the $20 Call options expiring in April and July 2010.
You should now see that the options premiums that you collect of $1,200 every 4 months can also act as an additional income you can invest or spend. If you are an investor, and have never been taught this subject, then you need to call me to explain how this strategy may fit into your overall investing goals. I have elder clients over 70 who employ this strategy using blue chip stocks; hundreds of stocks have options traded on them.

Many variations exist with options. Remember PUT options mentioned above? They can help protect your portfolio from losses and protect a profit you've earned. That topic will be addressed in my next blog post, so stay tuned.

~Barry Unterbrink

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