Hedge Your Bets
Two classic strategies will help you cope with today's volatile market.
One thing that hasn't been going down in this market is the cost of stock options. High volatility makes options costlier than they usually are. That's a drag if you are in the market to buy. But it's a boon if you're a seller.
Below we outline two popular strategies that involve selling options. You don't have to be a pro to pull off either one, but be sure you understand the basics. To bone up, go to the Options Industry Council's Web site (www.optionseducation.org).
1. Sell a covered call
Selling a call option against a stock you own can generate extra income when you're not expecting much appreciation from the stock. The income will give you some protection if your stock dips in price, but it won't shield you from a sharp fall.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
By selling a call you give the buyer the right to buy your stock at a prearranged price, known as the strike price. You effectively bet that your stock won't rise much during the option's term, which can run up to two years. You're giving up any potential stock gains in return for a cash payment.
Say you own 100 shares of Burlington Northern Santa Fe (symbol BNI), trading in early December at $72. By selling a call expiring in January 2010 with a strike price of $75, you could have earned a $14.40-per-share "premium" at that time. Because of volatility in the stock market, that call price was about $2 more than what a similar option would have sold for in early September. Options are sold in bundles of 100, so your total take would be $1,440, minus commission. (Option prices move with changes in the price of the underlying stock; also, option values fall as the expiration date draws nearer.)
If the railroad's shares don't rise above $75 before the expiration date, your $1,440 proceeds from selling the option, plus possible appreciation of up to $3 a share and dividends worth $1.60 per share, represent a potential annualized return of 23%. But if the stock soars above the strike price, you'll be obligated to sell your stake to the call buyer for what will then be a bargain price of $75.
If your Burlington shares fall below $56 by the time of the option's expiration, the decline will more than cancel out the premium and dividend income. But you'd lose less than you would had you not sold the calls in the first place.
2. Put on a collar
If you're willing to give up some potential gains on a stock you already own in return for limiting your losses, consider establishing a collar. This involves selling a call option (as discussed at left) and using the proceeds to buy a put option, which gives you the right to sell your shares at a prearranged price. A collar effectively locks in a narrow price range for your stock during the option's term for little or no out-of-pocket cost.
For example, in early December you could have taken the $1,440 you earned by selling Burlington Northern calls and used it to offset the $1,320 cost of buying puts with a strike price of $70 and the same January 2010 expiration as the calls you sold. You have now guaranteed that the value of your shares will stay between $70 and $75 until January 2010, plus you can pocket the $120 difference in price between the calls and the puts as well as an additional $160 in dividends.
If the shares are at $75 or above when your options expire, you will have earned an annualized return of 7%. If the shares trade for less than $70 when the options expire, you still have a small, annualized gain of 1%, thanks to the dividend and the leftover proceeds from selling the call.
Thomas Schwab, chief investment officer of Summit Portfolio Advisors, a Denver firm that specializes in collars, says he aims for collars in which the potential gain is two and a half to three times as large as any potential loss. "Look for those situations where people think the stock will go up in the near term and, as a result, the call premium is rich and the put premium is not that expensive," Schwab advises.
Potential gains from a collar strategy are smaller than from selling covered calls, but in exchange you can rest easy knowing you've put a floor beneath your potential losses.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
-
Come as You Are: Wealth Management for Gen X
Gen X is stuck in the middle of kids and aging parents, but retirement's not far off. Time to prioritize, with help from Nirvana, The Eagles and David Bowie.
By Alvina Lo Published
-
New Job? Time to Start a 401(k) Plan
Whether you're starting a new job or have never opened a 401(k) account, it's time! Here's how to open an account in five steps.
By Adam Shell Published
-
Fed Goes Big With First Rate Cut: What the Experts Are Saying
Federal Reserve A slowing labor market prompted the Fed to start with a jumbo-sized reduction to borrowing costs.
By Dan Burrows Published
-
Stock Market Today: Stocks Retreat Ahead of Nvidia Earnings
Markets lost ground on light volume Wednesday as traders keyed on AI bellwether Nvidia earnings after the close.
By Dan Burrows Published
-
Stock Market Today: Stocks Edge Higher With Nvidia Earnings in Focus
Nvidia stock gained ground ahead of tomorrow's after-the-close earnings event, while Super Micro Computer got hit by a short seller report.
By Karee Venema Published
-
Stock Market Today: Dow Hits New Record Closing High
The Nasdaq Composite and S&P 500 finished in the red as semiconductor stocks struggled.
By Karee Venema Published
-
Stock Market Today: Stocks Pop After Powell's Jackson Hole Speech
Fed Chair Powell's Jackson Hole speech struck a dovish tone which sent stocks soaring Friday.
By Karee Venema Published
-
Stock Market Today: Stocks Drop Ahead of Powell's Jackson Hole Speech
Sentiment turned cautious ahead of Fed Chair Powell's highly anticipated speech Friday at the Jackson Hole Economic Symposium.
By Karee Venema Published
-
Stock Market Today: Stocks Rise After Jobs Data Lifts Rate-Cut Odds
Preliminary data from the Bureau of Labor Statistics shows job growth was lower than previously estimated.
By Karee Venema Published
-
Stock Market Today: Stocks Snap Lengthy Win Streak
The recent stock market rally ran out of steam Tuesday as sentiment turns cautious ahead of Jackson Hole.
By Karee Venema Published