Options for Today’s Volatile Stock Market
- by Laurie Itkin
With the exception of the flat years of 2011 and 2015, during every year since the Great Recession of 2008, the Standard & Poor’s 500 index has experienced annual returns far exceeding its long-term annual average. (The S&P 500 annualized return, including dividends, from 1871 to 2015 was 9.05 percent.) If you didn’t panic in 2008 (the year the S&P 500 fell nearly 40 percent) and kept your money in a well-diversified stock portfolio, you were rewarded handsomely.
Is this bull market over?
Despite the market’s flatness in 2015 and 2016’s worst start to a year ever, I’m not ready to give up on stocks and exchange-traded funds (ETFs) that are comprised of stocks. I agree with the position of Wharton’s Russell E. Palmer Professor of Finance, Jeremy Siegel: “stocks for the long run.” However, as a financial advisor, I have found there will always be investors who panic and sell into cash when a market correction occurs.
You can’t time the market, and no one can consistently predict the tops and bottoms. If you get out, how do you know when to get back in?
Wouldn’t it be great to find a middle-ground where you could participate in the potential capital appreciation of stocks while generating income and reducing volatility in a portfolio? Adding quality bonds to your portfolio used to serve that purpose, but with interest rates so low, current bond yields just don’t cut it.
That’s where options come in. Options pricing was my favorite class as an undergraduate student at Wharton in the late ’80s. At last there was a practical reason we learned partial differential equations in high school calculus class! I liked options theory so much that I got hired by an options market maker for a summer internship in Chicago. It was a fun summer, but I knew that a career as a market maker wasn’t for me.
A few years after graduating from Penn, I received a $1,600 inheritance from my grandmother. That’s when I bought my first shares of stock. In the early ’90s, it wasn’t easy or practical for the average investor with little money to invest using options. But with the evolution of the Internet and financial technology, placing an option trade today is just as easy as placing a stock trade.
It wasn’t until many years after my first stock trade that I placed my first option trade, which was a covered call. By then, I already had built a well-diversified portfolio of stocks and ETFs. When the lightbulb went on in my brain and I understood I could virtually “rent out” my stock for income, I was instantly hooked. You see, when you purchase nondividend paying stocks, you only profit from capital appreciation, if it happens. If you purchase dividend-paying stocks, you receive income even if there is no capital appreciation. And when you sell a call option against 100 shares of stock you own (known as writing a covered call), you can profit from capital appreciation, dividend income and call option premium (the immediate income you receive from selling the option). Of these three potential profit sources, only the latter is guaranteed.
There are many ways to construct a covered call, but typically you agree to sell stock you own (either dividend-paying or not) at a higher price in the future. You give up some potential capital appreciation in the future in exchange for guaranteed income. If the stock falls after you purchase it, you have received income to offset some of your loss. And if you structure and manage the position well, you can profit from modest capital appreciation and dividend income, as well as option premium.
Another way to use options is if you see a stock market correction as a buying opportunity. Instead of buying stock at its current price or placing a limit order to purchase stock at a lower price, you can actually get paid to wait for the stock to “go on sale.” When you sell a put option, you get paid income immediately as you commit to buy stock at a lower price in the future. Once I learned how to sell a put option, I dispensed with placing limit orders. I have always bought my clothes on sale, and I now I buy the vast majority of my stocks on sale too.
When people tell me the urban myth that trading options is risky, I shake my head and suggest they read my book, Every Woman Should Know Her Options. I attribute its Amazon best-seller status to the fact that it’s a sound investment move for everyday investors. Are there risks involved with these conservative option strategies? Of course there are. But the risk is lower than purchasing stock by itself.
DISCLAIMER: The information contained herein is strictly for educational, informational and illustrative purposes, providing commentary, analysis, opinions and recommendations and should not be considered investment advice for any specific subscriber or portfolio or an offer to sell or a solicitation to buy any security.