Using Options to Reduce Risk in Your Portfolio
Investors generally think of options as a tool to boost profits by speculating on whether a stock will move higher or lower. And while options can be used in that manner, they can also be used to hedge a portfolio and actually reduce risk.
Options come in two forms: calls and puts. A call gives investors the right, but not the obligation to purchase 100 shares of stock, while a put gives investors the right, but not the obligation to sell 100 shares of stock. You can also sell calls and puts, which mean you have the obligation to sell or buy at a specific price, should the option be exercised, while keeping any profits from the upfront sale.
Used separately or in combination, these four option types can keep your portfolio’s returns as high as possible, while keeping risk as low as possible.
Simple option strategies you can employ to reduce risk
One of the most commonly used option strategies is also one of the best risk-reduction tools available to everyday investors – the covered call. A covered call is simply when an investor sells a call, meaning they have the obligation to sell 100 shares of stock at a specific price should the stock rise to that price point, while simultaneously holding 100 shares of the same stock.
For example, let’s say you own 100 shares of XYZ at $50 per share. You decide to reduce your risk of holding the stock by selling call at $55 per share and pocket the profits on the sale of $200. If the stock stays below $55 per share, nothing happens – the call expires worthless and you keep the $200. If the stock climbs above $55 per share, you must sell XYZ stock. That means you won’t be able to take advantage of any upside beyond that price, but you still profit $700 – $500 in gains from the stock rising from $50 to $55 and $200 from selling the call.
Another low risk strategy aimed at taking advantage of possible opportunities is selling a naked put. In this strategy, you sell a put – once again profiting up front – while taking on the obligation to buy 100 shares of a stock should it fall to a predetermined price. Using this strategy allows investors to speculate on possible value stocks without having to buy the stock outright and miss out on other potential opportunities.
Taking from our previous example, let’s say you decide XYZ stock is a good buy if it falls to $45 per share, but you don’t want to buy 100 shares at its current price. You sell a naked put for $200 at $45 per share and pocket the $200, which is kept regardless of whether the option is exercised or not. If the stock does nothing, you keep the profit and the option expires worthless. However, if the stock does drop to $45 or below, you’ll be obligated to purchase 100 shares at $45 – even if the stock falls below that level. The upside is that if you find out a stock is worth purchasing at that value, then it’s still a good buy, even if you would’ve otherwise purchased it cheaper.
By incorporating options into your investment portfolio, you open the door to a plethora of new trading strategies and risk-reducing investments. Combination strategies like the covered call can help you reduce risk and boost returns in stocks that don’t vary in price quickly while naked puts allow you to speculate on stocks without immediately taking on the risk of buying the stock. Options can be used to both boost returns and manage risk even in conservative portfolios.