Options as hedges: one safe, the other downright dangerous!

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Yesterday I mentioned an interesting article from the Tycoon Report, that talked a little about ETF’s. The same article gave a great summary about using options as a hedging tool …

… but, watch for the subtle difference in using two different types of options to do essentially the same thing … one relatively benign, the other can put your whole financial house at risk!

Here’s what the article had to say:

What strategies to incorporate now in the market to increase your return and decrease your risk? The market and the economy have been ugly lately.  [Just two of these] best strategies for this type of market are:

1.  Selling Call Options –An investor who sells calls believes that the price of the underlying stock (or ETF) is going to remain stable or decline.
    Remember when selling calls that:

•  Your maximum gain is the premium received

•  Your maximum loss is potentially unlimited

•  Your break-even is the strike price plus the premium received

2.  Buying Put Options –An investor who believes that the price of a stock is going to fall would buy a put option on that stock (or ETF), etc.

    Remember when buying puts that:

•  Your maximum gain is the strike price minus the premium paid.

•  Your maximum loss is the premium paid.

•  Your break-even is the strike price minus the premium paid.

Now, I’m not really an options trader – so don’t ask me for any ‘power strategies’ on this – read the Tycoon Report instead … it’s free!

But, I do know that selling naked calls is a dumb move … you can be liable to cover the entire stock purchase if you are ‘called’ and your downside can be theoretically infinite! Tycoon Report says:

If the call writer (seller) is uncovered (naked), and does not own the underlying stock, the potential loss is theoretically unlimited, since there is no ceiling on how high the price of the stock may rise. 

Why ever do it … particuarly when Buying a Put essentially produces the same result for absolutely minimum risk?!

For those who aren’t familiar with them, don’t just dismiss Options out of hand, the power of options is that they allow you to control a whole share/stock (well, usually you have to buy them in ‘lots’ of 100) with only a small ‘down payment’ known as a premium. Depending upon the option, you can gain the entire upside of the transaction …

… let’s say you buy a call on a stock that moves from $10 to $15 …. VERY OVERSIMPLIFIED: you might get the entire $5 increase just by putting up the, say, $0.50 per share ‘premium’ … 10:1 on your money. Not bad!

The problem is that the same works in reverse: if you sell a call on a stock that moves the wrong way (in this case you are ‘betting’ that it will go down … but the price skyrockets, say, from $10 to $50, you are in a whole world of hurt, because YOU have to come up with that $40 per share and give it to the guy who bought the Call Option from you!

Here are the FOUR BASIC OPTIONS for investing in options [pardon the pun]:

Buy Put
Sell Put
Buy Call
Sell Call

Here are times when I think it is safe to use Options:

1. When you have bought the actual stock (say, 1,000 shares of Apple, Inc. – Stock Symbol: AAPL), but are worried that they might drop, even though your are fairly certain that they are about to skyrocket (still sounds like speculating to me). Then you might buy 10 lots of Put Options, which (for a small premium that you essentially ‘lose’) will protect you against a price drop: you get to sell them to the sucker who sold the Put for the agreed price (usually, what you paid for the shares BEFORE they tanked … nice!).

In practice, I only buy stocks that I think are undervalued, will go up over time (I don’t really care when), hence am quite happy to hold on to – if I get caught in a down market, I will likely hold if I happen to get caught out. More likely, I will have already traded out of it using technicals (i.e. black magic and witchcraft … it’s little more than that), and use a Trailing Stop Loss to help protect me if the stock should fall.

I happen to prefer carrying the risk of a sudden and catastrophic crash rather than paying the small’ish premium for the Put. But, could equally recommend buying the Put. Personal choice, I guess.

2. When I own a stock that I think will trend up over time … isn’t that all of them 😉 … but, not dramatically so, then I may Sell a Covered Call (means that I also own the underlying stock), which is almost like ‘renting’ the stock out to somebody else for a few days/weeks and getting a small premium. Surprisingly, unlike selling the deceptively similar so-called ‘naked’ call (where I don’t actually own the underlying stock) this is a super-low-risk strategy … low, in that you don’t see yourself losing money.

In actual fact, you can lose money when the share goes up higher than the sell price that you set on the call and you have to hand them over to the buyer, while watching the price shoot up even further – to his benefit, not yours! So, it works best with a stock mildly rising in price (of course, the market is not always stupid and reflects volatility in the price of the option).

3. When you are retired and want to shift most of your money into nice, safe, boring inflation-protected Bonds (TIPS from within a tax-shelter; certain MUNI’s outside), but still want a little ‘gamble’ on the stock market. Then, why don’t you allocate, say, 5% of your portfolio and Buy some calls over a whole of market ETF (I know, I know … just yesterday I said that ETF’s were yada yada yada … this is a Making Money 301 wealth-preservation strategy; that’s a whole different enchilada to what we were talking about yesterday!)

… but, before you even think about 3. (a) buy a copy of Zvi Bodie’s excellent book for retirees: Worry Free Investment and (b) see a financial adviser (this is your whole future, we’re talking about).

Now, this wasn’t meant to be a primer on Options, so forgive me if I cut a few corners … I just wanted to let you know where I would consider them …

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