Although this column is primarily about the energy sector, I also write a weekly column for Investing Daily that is published every Tuesday. These columns are often about investing in the energy sector, but I cover broader investment and personal finance topics as well.
Incidentally, I also now cover the utility sector for Investing Daily’s Utility Forecaster, where I write weekly columns and manage a couple of portfolios. This MoneyShow article highlights three of my top picks from our growth portfolio.
Today I want to share one of my recent columns, which describes a strategy that can easily and relatively safely add a few percentage points to your annual returns regardless of your investment style or sector interests. If you are only interested in reading my thoughts about the energy sector, I will have something new up before the weekend.
Expand Your Horizons
Conventional wisdom states that trading options is risky. Indeed, it can be. For that reason, many people won’t trade options at all, because they see it more akin to gambling. But it doesn’t have to be risky. It comes down to understanding and managing risk.
Today I describe how to build a portfolio at a discount, using a low-risk option strategy that will add several percentage points to your annual returns.
I will describe the steps I would (and have) taken to allocate a $100,000 cash investment into stocks by utilizing options.
First, I want diversification. I want to divvy-up that $100,000 into about eight to 12 companies. Consequently, my individual holdings will be divided up into different blocks of stock in the $8,000 to $12,000 range.
Next, I need to decide how much risk I am comfortable taking. An aggressive strategy might concentrate these holdings into two or three sectors. A more conservative style would divide the holdings across the 11 broad sectors of the S&P 500: Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Information Technology, Telecommunication Services, Utilities, and Real Estate.
Again, this strategy can be made more or less aggressive by concentrating more holdings into a defensive sector like Utilities, or into a more sensitive sector like Information Technology.
The next step is important due to the nature of options pricing. An option represents 100 shares. In order to utilize options to improve our returns, we will deal in 100 share blocks. This limits the trading price of the companies we are interested in up to about $120 a share (assuming a diversified $100,000 portfolio).
The reason is one option for a stock with a price of $120 a share will represent $12,000 of stock. That’s about the maximum we want to allocate to a single position in this portfolio. This rules out a company like Netflix (NSDQ: NFLX) for this exercise, because at $345 a share one option represents $34,500 of stock — far more than we want to concentrate in one position in a $100,000 portfolio.
Alternatively, for shares trading at much lower allocations, we can trade several options. For example, five options of a company priced at $20 a share will represent $10,000 — right in line with our hypothetical allocation in this portfolio.
Case Study: WMT On Sale
Next we need to select companies. I won’t go through the entire list, but will provide one real-life example from my own portfolio.
In May, I was interested in adding consumer staples bellwether Walmart (NYSE: WMT) to my portfolio after a recent sell-off. But instead of buying 100 shares of Walmart for $87.53 each, the closing price on May 4, I sold one put option with a strike price of $85.50 for $1.67 a share. The expiration date was May 18.
The possible outcomes of that trade were:
1) Walmart would close above $85.50 on May 18, which meant I simply kept the $1.67/share premium. I could have then sold another put option; or
2) Walmart would close at or below $85.50, which meant I still kept the premium but I would have to buy the shares for $85.50.
Walmart closed at $83.64 on May 18, so I was assigned 100 shares. My cost basis was $85.50 minus the $1.67 premium I had received for a total of $83.83 per share. That was slightly higher than the actual closing price that day, but a 4.2% discount from the price on the day I entered the initial trade.
Consequently, the first step in building out the portfolio is to purchase shares at a discount using options. In this case, I was paid to risk buying $8,550 worth of Walmart shares that I wanted to add to my portfolio anyway.
Had shares traded above $85.50 on the expiration date, I would have earned a two week return of $1.67/$85.50, or 2% on the money I put at risk. I would have simply kept repeating this exercise until I was assigned, banking the premium each time the option expired worthless.
In this case, the first time was the charm, but I have banked half a dozen premiums before finally being assigned shares. The key here is to only sell puts on companies that you want to have in your portfolio.
Flip the Script
The second step, once you own shares, is to sell call options against them. As soon as the 100 shares of Walmart were in my account, I sold a $90 call option against them with a September 21st expiration date. For this, I received $1.60 a share, which I get to keep no matter what happens. This further reduces my cost basis to $82.23 per share.
What are the possible outcomes on September 21? If the share price closes above $90, then my shares will be called away. I forego any profits above $90 for the premium I received. This would amount to an overall return of 10% in about four months (which includes a dividend that will be paid the first week in September).
If the share price is below $90 on September 21, then I simply sell another call option against my position, collecting another premium and further reducing my cost basis.
In this case, the premium would have added an additional 1.9% return to my shares in four months.
Pros and Cons
What’s the catch? This strategy doesn’t protect you against a steep decline in the price of your shares, but it does add a few points of return to them. So if Walmart shares fell 20%, I will still take the brunt of that decline (but not all, because of the premiums I received). Of course this is why we diversify, and why we choose blue-chips if we are worried about risk.
Second, you are capping your potential gains for the certainty of the premium. It’s important to mentally prepare for that, in the off-chance that your shares rise far beyond the option strike price. That’s a low-probability event, which I am willing to forego to collect those premiums.
It may occur to you that you can simply conjure money out of thin air by selling put options. It’s true, you can, but you have to be aware of the consequences. If I had sold five Walmart options and they were exercised, I would have banked over $800 initially in premiums but then I would be obligated to buy more than $40,000 of Walmart stock. So don’t stick your neck out farther than your cash can cover.
You can repeat this process with bellwether stocks in different sectors until your portfolio is filled out. It will take a little time, but you can speed it up or slow it down based on the time frames and strike prices you choose.
You may even find that you prefer to simply sell options that have a low probability of being exercised to actually owning the stock. Your returns will generally be low (as will your risk), but it will still beat what you could earn from having that money parked in a money market account.