Call and Put Option
Talking about the uses of the Call and put option in a trading strategy often makes the reader immediately assume RISK! These instruments form part of the derivatives family and the typical association with derivatives is usually risky, leveraged tools. Other members include Futures, CFDs and Warrants.
And sure, when these instruments are not correctly used, they can lead to problems. However, some basic rules, along with a solid trading plan, can help check that risk, and actually channel them in a far more positive and lucrative way.
Human nature, particularly in the trading and investing space often focuses on where the home run is. After all, that immediate gratification from a trade that makes hundreds of percent return in a short period of time must be very appealing. In the hunt for this kind of return, using a derivative to leverage up, seems an obvious choice. But big returns can mean big risks.
Analogy: Baseball in the 1920’s
If we consider a baseball analogy of hitting a home run (a big winning trade) this is the big goal for many. However, there is a trade off. Back in the 1920’s, while at the New York Yankees, Babe Ruth held the record in major league baseball for the highest number of home runs. An impressive record and one any baseball fan would regard with envy. However, during the same season, he also held a less auspicious record – that of the most number of strike outs – quite a record than you wouldn’t want. So there is a trade off and in reality, trading is no different.
For the trader, pursuing a home run strategy, you need to be very comfortable with getting wiped out on a large number of trades. Most retail investors and traders do not have the stomach or the psychology for this kind of strategy, so what instead can be done?
How about the use of call and put option strategies.
Rather than speculate on the market, and seek a home run while running the risk of a strike out, we use the call option as a tool to generate regular and up front income. The strategies we use include the covered call and its racier cousin, the calendar spread. Covered calls are time tested – in use for decades and over time is shown to be an outperformer. Take a look at how the buy/write index has outperformed the broader stock market.
Needless to say, returns do vary, but by creating the market, through selling calls over your stock, rather than the more dangerous speculation on the market (hoping) you are likely to enjoy a long term better outcome – not to mention a great deal more peace of mind, but more on that shortly.
In addition, covered calls is a strategy where time and specifically what is referred to as time decay, is working for you, rather than against you, as it typically is with more speculative derivatives trading. As such, and certainly in my experience of almost two decades as a professional trader, this is one of the most consistent strategies in the market place.
So what about peace of mind?
There are occasionally times in the market, where volatility may be increasing, levels of uncertainty rise and the anxiety felt by many a trader and investor can become uncomfortable. Picture this, you have just retired and have exposure to the stock market. Perhaps your portfolio is skewed toward the banks and other higher yielding stocks, to help you generate some cashflow.
And you and your partner are planning on heading away for a break – that well deserved holiday – and you don’t want to have to keep one eye on your investments, while away. Perhaps you are going somewhere more remote, without good quality communications or better yet, you just want to switch off. What do you do? Sell before you go away and sit in the very low yielding cash market?
This is where buying some put options for protection, can afford you some peace of mind. Let’s say you paid around $26 for your NAB shares and they are presently around the $33 level. You want to keep the shares for the upcoming dividend. Why not buy a $31 Put option, effectively giving you the ability to sell the shares for $31, irrespective of what they may be worth. Were the stock to retrace, to $26, I am sure you would be happy to have the chance to sell for $31, and if they held their ground, well at least you were insured! This is an example of using derivatives for risk management.
But you have to pay for insurance!
Yes you do – insurance costs money and the bigger the policy, the higher the premium. So how can we, as options trading experts, cover that cost, so that perhaps you have no out of pocket expenses to insure your position?
This is where we would sell a call option – and the income from this, would help to offset if not on an ongoing basis cover the cost of the insurance. Now you have peace of mind, insured stock and it hasn’t cost you any out of pocket expenses – just one of the benefits of becoming an expert in using options as part of your risk management.
This strategy is called a collar and is a classic example of the use of call and put option in harmony, enabling the investor to achieve their financial objective, as well as manage risk. In fact, this is one of the more prudent risk management strategies out there and has many uses beyond “heading away on holiday and want the position hedged”.
Another example would be where you are using certain stock holdings as collateral on a margin loan. If the valuation of your stock drops, this could cause problems within your margin loan – such as a margin call. And so again, to avoid this nasty surprise, buying some insurance with a put option “preserves” the value of your stock and therefore insulates you from risks such as a margin call.
On the surface the call and put option get a bad rap – seen by many as purely speculative tools that are more for the “punter”. However, once harnessed for their income generating and protection attributes, they should become a key part of any savvy investor’s approach to the market – not only assisting in the outperformance of your investments, but also when needed, providing you with the peace of mind of an insured and protected position.