2 Simple Stock Option Strategies to Boost Your Portfolio

Stock options may sound scary and complicated, but they don’t have to be. What if I told you that you could make over 12% of the equity you have in a stock every year without the price of the stock ever changing? That would outperform most mutual funds! All you have to do is have a basic understanding of what a stock option is and how to incorporate them into your portfolio!

We won’t be deep diving options today, but I want to explain some basic concepts. There are two types of options: Puts and Calls.

When you buy a Call, you are buying a contract that gives you the right to buy a stock at a certain price (the strike price) by a certain date if you so choose. Conversely, buying a Put gives you the right to sell a stock at a strike price by a specified date.  Just like we learned with stocks, for every buyer there needs to be a seller. In both Calls and Puts, the option seller is obligated to fulfill the order at the strike price if the option buyer exercises their right to sell or buy the stock.

Options are traded on the market just like stocks. When you trade an option you are not trading the stock, but rather a contract regarding the stock. Each contract (with some exceptions) represents 100 shares of the stock and the dates that they are good through end on the 3^rd Friday of each month (i.e. you would choose to trade contracts expiring 18 Aug 2017 or maybe 15 Sep 2017 if you so choose). If the expiration date comes and goes without the option ever being exercised, the contract is terminated.

The amount that people pay for the contract is called the premium and it is usually priced per share such that a $0.30 contract will cost you $30 out of pocket to buy. The premium goes to the seller and is theirs to keep even if the contract expires. This is how we make our money.

Options can be very risky if you don’t know what you’re doing and have the potential to lose you a lot of money. While there is never a ‘no-risk’ situation, the strategies outlined below provide relatively little risk to the careful investor and are excellent ways to increase liquid assets in your account.

My recommendation is to never put more than 10% of your entire portfolio into options contracts.

1. Covered Calls:

In the name of this strategy, ‘covered’, means that you own the shares of the stock for which you are selling the options. So, how does it work?

Let’s say that you own 100 shares of Zynga ($ZNGA) and for the last year it’s been pretty stagnant and keeps fluctuating between $2.50 and $3.00 per share. Frankly, you wouldn’t mind selling the stock, but also want to take this opportunity to make more cash with your shares than you otherwise may have just by selling them. You decide to sell a Call option on Zynga.

You think that $ZNGA won’t go up as high as $3.50 per share in the next month, so you decide to sell a contract with the expiration date on the third Friday of next month with a strike price of $3.50. Prices vary and have a number of inputs, but often contracts sell for around 1% of the stock’s price.

I decide I want to purchase your option contract and pay you the asking price of $0.03 per share ($30 total). Now, I have the right to buy the stock from you at $3.50 in the next month even if the market price goes all the way up to $100 per share and you would be obligated to sell the 100 shares to me at the strike price.

There are two sides to the risk here. On the low side, the stock could go down in value and your equity would decrease THE SAME AS IF YOU HAD JUST HELD ON TO THE STOCK. On the high side, you don’t actually lose money, but you lose potential. You got $30 in premium plus $350 in the value of the shares you sold. The potential is that you could have sold those shares for $10,000 if the price really jumped that high.

More realistically, the $ZNGA stays right where it was and stays around $2.70. The contract expires, I choose not to buy the stock from you and you get to keep my $30 premium. Well, you think to yourself, I should do that again! And so you do for the rest of the year.

1% per month may not seem like a lot, but annualized at that same rate and you’re making almost 13% each year on money that otherwise would be sitting idly in your account. That’s outperforming most mutual funds! Don’t forget, if the price of the stock really does keep going up slowly, you just raise the strike price you sell the Call at. Maybe next month the price you don’t think it will hit is $4.00 instead of $3.50. Now you’re making money in the value of the stock and in the collected premiums!

2. Cash-Secured Puts:

In this scenario, you have cash in your account and see T-Mobile ($TMUS) as a stock that you wouldn’t mind owning. You decide that rather than purchasing the stock, you are going to grow your account by selling Puts.

Think of Puts as insurance. I’m worried that the value of TMUS is going to drop and if that happens, my 100 shares will be worth less than the $66.00 they are today. So I offer to purchase insurance (the Put contract) from you where you’ll buy the stock from me at $62.00 per share by the 3^rd Friday of next month if I so choose.

Just like with the calls, I pay you a premium of about 1% of the share price (although at the moment of writing, similar Puts on $TMUS are selling for almost 2%!) for the contract. And now we wait to see what the stock does over the next few weeks.

Take a look at the risks associated with this strategy. If the price of T-Mobile plummets in the next month down to $20 per share, you are still obligated to buy the stock from me at $62.00 which is an immediate loss of $42 per share or $4,200 in value (but you got the almost hundred dollar premium to keep so there’s that).

Does this seem risky? Yes, but this was a stock that you said you wouldn’t mind owning and had you bought it at $66, you would be down near the same loss anyway!

Now let’s look on the other side, if the skyrockets, you lost out on the opportunity to make a lot of money had you simply purchased the stock. So it was only lost opportunity. Either way, you still got your premium.

If the stock stays roughly the same or even slowly and steadily changes over many months, you keep your premium and do the same trade the next month increasing the cash value of your account by more than a lot of mutual funds can consistently do!

So there you have it. Did you notice that the risk profiles were the same? Those were  2 simple and low-risk strategies for incorporating options into your portfolio. There are a lot more ways to trade options that involve more risk, higher rewards, larger losses, and margin accounts. If you want info on that feel free to reach out to me. Many brokers offer pretty good insights as well. I personally use TD Ameritrade which has a whole slew of educational videos and tools to help you. If you have any questions or concerns, please let me know!