Many conservative investors are scared away from options because of the horror stories and the "get rich quick" schemes. But even the most conservative stockholder should learn about using put options to protect the stock portfolio. Buying a put option to protect a stock position before the company’s earnings announcement constitutes a prudent management of risk. One may also buy index put options to protect the entire portfolio when a market correction appears likely. Some conservative investors maintain a small ongoing position of index put options as “portfolio insurance”.
Selling options as a method for generating income is well known, but largely misunderstood, because of the marketing hype and the horror stories of misuse. The covered call is created when one sells a call option against the trader’s stock holding and is widely considered the safest of all options trading strategies. In fact, some brokers only offer covered calls to their clients who wish to trade options.
Selling put options has a notorious reputation. Like many things in life, selling puts may be dangerous in the wrong hands. Following three simple rules opens selling put options to the conservative investor:
1. Only sell puts on solid blue-chip stocks.
2. Always have the cash available in the account to buy the stock if the put is exercised.
3. Always have a contingent stop loss order entered that will execute automatically if the stock pulls back below the break-even price.
Wilshire Analytics published a study that compares the buy and hold strategy on the Standard and Poors 500 companies with selling covered calls and selling cash secured puts on those stocks. Over a period of thirty years, the selling cash secured puts strategy outperformed the buy and hold strategy. More importantly, the risk of these option selling strategies, as measured by the standard deviation of the returns, was over 30% less than the risk of the buy and hold approach. The maximum account drawdowns over this thirty-year period were about 30% less for the options strategies, and the recoveries from the drawdowns in the options strategies were almost half that of the buy and hold. Many academic studies have confirmed these results.
Have I piqued your interest? Come to the Traders EXPO on July 22nd in Chicago and hear my presentation, How Conservative investors Use Options. Introduce yourself. Maybe we can get a cup of coffee and discuss trading.