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How Options Can Help Your Portfolio

Although the terminology may take some getting used to, options are just another investing tool for generating income or protecting you from a market sell-off.

For some people, options trading conjures either fantasies of instant riches or nightmares of losing everything. But those are the visions of market-timing speculators, not long-term investors. For most investors with a long-term view, trading options is a way to protect individual stocks or an entire portfolio from a downturn. Moreover, used conservatively, options can generate cash in amounts that far exceed the average dividend. This guide is meant to walk you through some of the basics.

First, the nuts and bolts: An option is a contract that gives its holder the right either to buy shares at a fixed price (a call option) or to sell shares at a fixed price (a put option). The price at which you can either buy or sell the underlying shares is the strike price, and the price of the contract itself is the premium. You’ll pay the premium if you purchase an option, or you’ll pocket the premium if you sell a contract to someone else. An option contract represents 100 shares of the underlying stock, and the contract expires on a fixed date; the holder may exercise an option on or before that date. Listed premiums are multiplied by 100. For example, if the premium is listed at 50 cents, it means the cost of buying that contract is $50.

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The first hurdle newbies face is understanding the options chain, a matrix of information about available contracts that you can find on most brokers’ sites or trading platforms. The vast majority of brokers make it simple to read the matrix and do not confuse you with the actual symbols used by the exchanges. Most large-company stocks, such as Apple (symbol AAPL), Disney (DIS), Gilead Sciences (GILD) or JPMorgan (JPM), are good candidates for options trading; they’re said to have liquid option chains. Many smaller companies, such as Square (SQ), have option chains that are also easy to trade.

While many thousands of stocks have options with one expiration date per month—the third Friday—roughly 500 stocks have options that expire every Friday.

These chains have many numbers on one screen, so at first glance they may look confusing. But they are, in fact, very orderly. You’ll find expiration dates for the options either running along the top of this grid or in a drop-down box. Available strike prices are typically found in the center column of the table. Most brokers align information for a specific strike price the same way: puts to the right, calls to the left. The bid is what someone is willing to pay for the option, and the ask is what the seller wants to receive (similar to when you are buying or selling a stock).

As with stocks, the daily volume is listed for every option. In the column labeled “Open Interest,” you’ll find the number of contracts currently open. The greater the open interest, the narrower the difference between the bid and the ask, making the option easier to trade.

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Once you get past the argot and absorb a few new terms (we have assembled a glossary below), options trading doesn’t look that much different from buying and selling stocks and exchange-traded funds. Options are just another investing tool that could become an integral part of how you generate income or protect yourself from a market sell-off.

Ready to trade? Consider two popular ways to use options to protect your capital and generate cash and income.

Selling covered calls

A covered call is an option contract that is backed, or covered, by 100 shares of a stock that you own. The person who buys your call has the right to purchase your 100 shares at the strike price at any time, until the option expires. In any given month, selling calls generates income typically ranging from a few bucks to 1% of the value of the shares, or perhaps more. Stocks with call options that expire every week can generate double the cash collected from selling a single monthly option.

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The sale of a call with a strike price above the share price is said to be out of the money and can generate income in two ways: the cash collected when the call is sold, and the profits made if and when the buyer exercises the contract and buys the shares.

For example, let’s say you own stock in Disney, trading at $102.02, and you sell a call with a strike price of $115, expiring in 29 days. You collect a premium of $153 per contract (the $1.53 price of the contract listed in the options chain multiplied by the 100 shares represented by the contract). This is the equivalent of a 1.5% monthly dividend yield. If the buyer exercises the contract (the process of exercising is known as assignment), you’ll earn an additional $12.98 per share—the difference between the strike price and the price of the shares when you sold the call. Total profit per share is $14.51, a 14% return.

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Sound too good to be true? Sometimes it is, depending on the whim of the market. Let’s say Disney stock rises to $120 a share. Then, the call is in the money, and the buyer is almost certain to exercise the option. (A call contract is not automatically exercised; it’s up to the buyer to do so.) In this case, you’d lose out on $5 per share in profit on the 100 shares you sold to fulfill each contract. Forgone profit is the biggest potential downside of selling calls. And despite the trend toward commission-free trading, many brokers continue to charge assignment fees that range from $0 to $20 for each contract (the large brokers typically charge between zero and $4.95).

If you’re interested in covered calls but don’t want to execute the trading yourself, you could try buying a covered call ETF. These ETFs typically buy shares and immediately sell calls against them, limiting capital gains but increasing yields. At present there are 18 such ETFs. None is very large. The biggest, Global X Nasdaq 100 Covered Call (QYLD, $20), employs covered calls on stocks in the Nasdaq 100 index. It has less than $900 million in assets but has a yield of more than 12%. Such ETFs are a good place to start for someone who is new to calls and wants more income. That said, in volatile markets, calls sold on individual stocks have a greater potential to generate income.

Buying protective puts

You can protect your portfolio in a falling market with put options. When you buy a put, you have the right to sell shares to the option seller at the strike price. If that price is $90, say, and the underlying stock falls to $80, you can realize a $10-per-share profit by buying shares and selling them to the option seller. The strategy lets you hedge your portfolio—it’s akin to buying insurance, as the put will go up in value as the price of a stock or the market itself falls.

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Investors holding stocks for the long term avoid this multistep process by selling the put itself because it will have risen in price with the decline in the stock price. How much the put rises depends on how much time is left before it expires and how much more volatile the stock has become. Traders betting that the stock will continue to fall over that period will bid up the value of the put; the extra price they are willing to pay for the time until expiration is called, appropriately enough, the time value.

Using protective puts has three major limitations. First, there is no such thing as a foolproof hedge. After all, if the market goes up, you’ll lose money on the put. Second, it is difficult to manage these puts unless you are an active trader, because puts can vary widely in value from day to day, requiring you to monitor your portfolio closely. Third, puts are expensive.

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But fans of put options have an answer to these objections. First: So what if you lose some money when the market goes up? That’s the cost of insurance. Plus, puts can throw off huge profits when a stock falls suddenly and dramatically (think crash, not sell-off). In that case, the profit might erase the losses from a downturn in the share price.

Second: Less-active traders can always place a good-until-canceled order with their broker to sell the put at a specified price. Such a trade is automatically executed if the put hits that price as the stock sells off. Third: You can offset the high price of puts with cash from the sale of a call. And in a calm market, when you might find it least desirable to buy a put, puts are relatively cheap. When markets fall sharply, the cost of buying puts increases dramatically. But so does the cash from selling a call.

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Investors looking to hedge their stock portfolio overall can buy puts on Standard & Poor’s 500-stock index (SPX) or on an ETF tracking the S&P 500, such as SPDR S&P 500 (SPY).

Setting up an options account

When you trade options, it’s better to use limit orders than market orders. A limit order allows you specify the price at which you want a trade executed; a market order is executed at the next available market price.

But in order to trade options you must first apply to your broker for permission. Options trading rules vary widely from broker to broker—some restrict options trading in retirement accounts, for example. But all brokers adhere to a system of trading levels, each of which requires permission. These permissions vary slightly but are typically based on your trading experience, the size of your account and how frequently you trade.

The levels are built one on the other; each higher level includes the privileges of the levels beneath it. Most brokerage levels correspond roughly to the following:

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Level 1: You can sell covered calls.

Level 2: You can sell cash-secured puts and buy calls and puts.

Level 3: You can trade option spreads—trades in which you are buying or selling more than one option at the same time.

Levels 4 and 5: Forget about it. These levels give you the ability to sell naked calls and puts, something an individual investor should never do.

The language of options

Assignment: The process of an option contract being exercised by the buyer.

Call: A contract giving the buyer the right to buy 100 shares at a specified price on or before a specified date from the seller. Individual investors should sell only covered calls secured by shares of the underlying stock. Selling naked calls, or calls not supported by shares that you own, is too risky for most investors. In a rising market you’d be forced to secure the shares at ever-higher prices.

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In the money: An in-the-money put is when the strike price is higher than the share price. An in-the-money call is when the strike price is lower than the share price.

Option chain: The list of option contracts available for a stock.

Out of the money: When the strike price of a call is above, or the strike price of a put is below, the current share price.

Put: A contract giving the buyer the right to sell 100 shares at a specified price, on or before a specified date, to the seller. Individual investors who sell puts should sell only cash secured puts, backed by cash or a margin-loan equivalent of the cost of buying the underlying shares. A naked put does not have this support and is far too risky to be sold by most investors, because in a market downturn the option seller may have to buy the stock from the put buyer at a substantial loss.

Strike price: The price at which the seller of the option must either buy or sell shares.

Premium: The price of an option contract. A premium is multiplied by 100 to determine the cash value of the contract. A 50-cent premium equals a contract worth $50.

Time value: The part of an option premium representing the value to the buyer of the time remaining until the option’s expiration. Time value falls as an option nears expiration, a process called time decay.

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