Options for Your Investing Benefit, part 2

The last blog post we discussed using exchange traded options to reduce your investment costs. View the last post for the skinny on that. Specifically, we sold Bank of America January 20 call options, receiving $1,200 for our efforts, reducing our cost from $16 to $14.80. This post, I will switch and explain the role of 'Put" options to complement your stock investing.

Put options allow the owner of the options to sell shares of stock at a preset price. We will follow the prior example using Bank of America (BAC) stock. Today, BAC is at about $15.15 a share. A buyer of the shares in recent weeks may have lead to some sleepless nights; the share price is very volatile - touching $19 about three weeks ago. Our assumption, like before is that you are bullish longer term on the prospects for BAC. But...you wish to protect your position against uncertainly and a potential loss should the stock fall to $14-$13-$12 or below.

Stated above, owning put options will protect you from big losses. While we were happier campers at $17, we'll play and await our price target of $20 next year. The put options would allow you to sell your 1,000 shares of BAC at the strike price, $15, $14, etc. up through the options expiration, January 15th, 2010. The price you will pay for the option depends on the protection you seek. Today the $15 put option would cost you $1.30 ($1,300 to cover 1,000 shares). The $14 option cost is $900. The option you buy will provide a floor at which you cannot lose money beyond- $14 or $15 in this example. Notice that in this transaction you are the buyer of the option; you were the seller of the call options when you originally bought your shares at $16. So now you pay the $900 to buy protection. You took in $1,200 when you sold, and now pay $900; so you are about $300 ahead in option income. Let's look at numbers again... it's critical to understand this.

You bought 1,000 BAC at $16.00 = $16,000
You Sold 10 Jan. 20 Calls at $1.20 (collect $1,200)
Your cost of 1,000 BAC shares = $14,800
You Buy 10 Jan 14 Puts @ $0.90 (pay $900)
Your adjusted cost of your 1,000 BAC shares is now $15,700

This changes your profit picture a bit from last time, since BAC was $17.00 then. How? Your cost of the shares, at $15.70 per share is above the current price of $15.15. However, with stock options, you can always adjust your strategy on the fly. Follow me. You now have 20 options outstanding in your account. First, you sold someone the right to buy your shares at $20 (the January calls), and now you bought Jan. $14 Puts enabling you to sell your shares at $14 anytime until the Jan. 15 expiration date. You are protected on both ends now; you can bail out at $14 if things get really ugly, limiting your loss to $1.70 per share ($15.70-$14.00), or you can hope the shares rise back toward $20 and sell them along the way. If they rise above $20, the owner of the call options you sold will buy them from you at $20.

There's one more component to think of here. The 10 call options you sold for $1,200; they're worth just $170 now because BAC fell in price and the likelihood that it will rise to $20 in the next 10 weeks is less likely. You could close out this obligation by buying these options back for $170. Then, you could sell other call options and collect some more income - perhaps the Feb. or May 2010 series.

Takeaway on this: Options can enhance your income and protect your stock profits, but do limit your profits (the trade off) on the upside. They do require some extra work and babysitting of your portfolio also.

A slogan on stock market and investing emotions comes to mind: "Bulls make money, Bears lose money, and Pigs get slaughtered". Perhaps an options strategy will allow you to manage your stock risks better, and avoid the pig pen!

Barry Unterbrink
Chartered Retirement Planning Counselor