Musings on Performance – Options Strategies (Part 4)

In this final part of Performance series, I would like to briefly touch on two strategies that can increase performance. Or not.

Both strategies involve selling options.  In Covered Calls Strategy, you can sell call options on the stocks already in your portfolio, thus generating extra income.  For example, if you have $40 stock, you can sell a call option with a strike of $45, for, say $1.  If the stock stays below $45 before expiration, you simply keep $1 as extra income.  If, however, the stock advances above $45, you will be forced to sell it at $45.

Selling covered calls is a conservative strategy in the sense that you are trading cash upfront for future potential gains.  In most cases, out-of-the-money options will expire worthless, thus generating extra income for you.  However, a single large upward move in one of the stocks (for example, as a result of a good earnings report) can more than compensate for options premiums collected for all other stocks.  If in our example, that stock soars to $60 and you are forced to sell at $45, you’d wish you never knew about covered calls.

In the Selling Puts Strategy, you sell put options.  In the example above, you could sell $35 put for $1.  Then, you keep the premium if the stock stays above $35, but if it drops below, you will be forced to buy it at $35.  Unlike Covered Calls Strategy, this approach generates extra income while keeping your upside unlimited, seemingly the best of both worlds.  But there is no free lunch.  While it is also true that most options will expire worthless, allowing you to keep extra income, a big drop in stock price could wipe out all of your option income, and then some.  If that stock drops to $20, you will be a proud owner at $35.  In the event of a large-scale market decline or a black swan event, depending on how many options you sold, you may receive a margin call and your whole portfolio could be in jeopardy.

Both strategies are, in a sense, anti-lottery.  A likely outcome is that you are going to keep options premiums, earning you extra income, which will make your performance look better.  You have to recognize the risks, however, especially when selling puts, and use these strategies very carefully.  A single unexpected event, which in financial markets can happen quite frequently, could wipe out all of your gains and cause large portfolio losses.