Trading Options in Your Investment Portfolio – part 1   Leave a comment

There has been a lot of noise in the media lately about proprietary derivative trades. Derivatives in the form of Equity Options (commonly referred to simply as “Options”) are a mechanism that the average investor can use to help them limit risk in their investment portfolio for positions that consist of widely-held stocks or ETFs (Exchange Traded Funds).

I’m going to explain, as best as I can, how I have used Options in my personal investing. I am not a financial advisor, and this information is free for you to use at your own risk. You should carefully consider your tolerance for risk and carefully and thoroughly evaluate any investment. Most investments involve some level of risk. What I do with my investments is in no way an endorsement of the companies, related securities or the quality of the positions discussed. Neither is it a recommendation regarding the suitability of the investment positions for your portfolio. You have been warned.

What I have tried to do with options is to reduce or eliminate risk in the positions I’m trading and improve the consistency of my investment returns over time. As would be expected, I have had some winners and some losers but I’m satisfied with my results and have definitely avoided a number of large losses since starting.

If you are an investor in stocks or ETFs, you may benefit from options if you approach them correctly. By correctly, I mean becoming educated about what options are, how they are priced, how those prices vary and clearly understanding the very real risks and obligations they bring to the parties involved before you enter your first option trade. I started by reading a couple books and doing a lot of research on the Internet. Of the books I have, these two are the best for getting started:

  • Options Made Easy by Guy Cohen
    • This is a good book to go from knowing absolutely nothing about options to a good basic level of understanding about options.
  • Options as a Strategic Investment by Lawrence McMillan
    • This is a very good book with a lot of information in it. This is more of a textbook but will serve as a great reference.

If you are totally unfamiliar with options, I would suggest at least buying Options Made Easy and reading the first few chapters to get a handle on the terminology. Here are a few basic but important points to understand:

  1. Options are actually a form of a contract between a buyer and seller that obligates one party to buy or sell a stock or ETF for a fixed price for a limited period of time.
    • The stock or ETF is referred to as “the underlying”, meaning that it is the underlying asset on which the contract is formed.
    • The period of time ends on “the expiry (date)” and is the last day on which the contract is enforced or can be traded.
    • The fixed price is referred to as “the strike price”.
  2. Options contracts are generally structured to control 100 shares of the underlying for each contract. This is not always the case however, so be careful. Options contracts are derivative financial products, meaning that their prices are established based on multiple factors including the current price of the underlying, the strike price and the gap between the current and strike prices, the amount of time left in the contract, the volatility of the underlying, and so on.
  3. Option contract prices are quoted differently than stock prices. An option that is quoted at $0.50 means that the option will actually cost $50 (plus brokerage fees). This makes sense when you consider that the contract’s price represents the cost per share for 100 shares. In this example, 50 cents per share times 100 shares is $50.
  4. Brokerages usually have different fee structures for options trades than for stocks. Options trades will normally consist of a base fee plus a per-contract fee. For example, Fidelity charges about $8 per options trade plus $0.75 per contract for contracts over $0.60. Fees can have a significant affect on the end result of a trade and always need to be part of the equation.
  5. As I’m describing these trades, a “position” consists of a combination of the ownership of stocks/ETFs and options contracts and may include the short sale of options to a potential buyer. Since I use a cash account (no margin involved), any short option contract sales are “covered” – meaning that I will always hold the stock or the cash to fully provide for any obligations I have created by short selling an option contract.
  6. There are two types of option contracts – calls and puts. Calls will obligate a contract seller to sell a stock at the strike, and puts will obligate the seller to buy a stock at a fixed price (both for a fixed period of time dictated by the expiration). The seller of a call or put is said to be creating a “short” position when they sell an option because of the obligation that they have agreed to. The buyer of an option is the “long” side, meaning that the buyer has the right, but not the obligation, to buy or sell the underlying at the strike before or when the option expires.
  7. At expiration, options will automatically execute if they are “in-the-money”.
  8. Understanding the terminology of options trading is half the challenge of making good trades. Take your time and make sure you “get it” before you start trading. Investopedia is a great site for looking up definitions of terms you’ll come across when preparing to trade options.

Don’t worry if all of the above doesn’t entirely make sense. However, definitely make sure you completely understand all of the above before you actually place an options trade!!!

The next article will have some information about using “buy-writes” to offset risk. Buy-write option positions are a good beginning topic, but there’s still a lot to it and I don’t want this post to be huge…


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