Covered calls provide a potential income opportunity from trading options, but they involve risk and might not be suitable for all investors.
3 Option Strategies for the Long-term Investor
Options typically are associated with traders looking to implement relatively short-term strategies. But option trading strategies can also be used by long-term investors to help them better reach their financial goals.
“Long-term investors can use options to help gain additional income, protect against large losses, or long-term investors can use options as a stock replacement strategy,” said Brian Bachelier, vice president of active trading strategy at Scottrade.
Here are several ways options can be used to help the long-term investor. Although these strategies can help investors reach long-term financial goals, it’s important to understand the risks associated with each.
What is it? This strategy is used by an investor who has a long position in the stock, but also sells call options on that same security. A covered call generally works best when the price of a stock remains about the same as it was when you placed your covered call, since you forfeit upside gains for downside protection.
How can this strategy help long-term investors? Covered calls are generally used to offset some risk and increase investment income through a premium you’re paid by the buyer.
Example: Company X is trading at $50 a share. You think the price will remain relatively stagnant in the near term. As a result, you sell a call option on the security with a strike price of $51, meaning you might have to sell your stock at that price should it rise to that price or above. But you would still be able to keep the premium.
Risk: There is an opportunity cost for capping the amount you can receive at $51 per share. In addition, if the stock falls significantly, the premium you receive may not offset the loss in the stock position.
What is it? This strategy involves selling puts which obligates the investor to buy the stock at the strike price, if the option is exercised. The investor holds aside enough cash to make this purchase if the price falls.
How can this strategy help long-term investors? If you’re concerned that a stock you’re interested in buying is too expensive, a cash-secured put is one way to acquire it at a lower price. It can also be a source of income because the writer of the put option receives a cash premium from the buyer.
Example: Company X is currently trading at $100 a share. You’d be willing to buy 100 shares at $95 per share. In this scenario, you write a put with a strike price of $95 per share, and you must have $9,500 in your account to purchase the stock. In addition, you collect a premium for the contract.
If the stock price rises, you still collect the premium, but you would not be able to purchase the stock at $95.
Risk: If the stock price keeps rising above $100, you would miss out on the opportunity to purchase the stock at that price. In addition, if you do buy the stock at $95 per share, you assume the risk associated with that stock.
What is it? This strategy involves purchasing put contracts on stocks you own. The put provides you the right to sell the stock at the options strike price, effectively limiting losses from declines in the stock price.
How can this strategy help long-term investors? You effectively set a floor on your total loss, without putting a limit on the upside potential of the security.
Example: You purchase a stock for 100 shares of Company X for $50 a share. Over time, Company X trades for $70 a share, which is an unrealized gain of $2,000. You don’t want to sell, but you also want to minimize your downside risk. You can buy a protective put (meaning you must make a cash payment) at a strike price, such as $65 per share. If the stock reaches $65, you may enact your right the right to sell your shares.
Risks: You must pay a premium to buy a put. That premium effectively reduces your overall gain.
Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in the Scottrade® Options Application and Agreement, Brokerage Account Agreement, by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation, or by requesting a copy by contacting Scottrade. Supporting documentation for any claims will be supplied upon request.
A protective put strategy raises the breakeven on the underlying by the amount paid for by the put. If the underlying security stays above the strike price you can lose the entire premium upon expiration.
The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
The covered call option strategy may help generate income and offer limited downside protection, but does not provide full downside protection and may limit profit potential.
Examples used will show the deduction, or inclusion, of commissions and other costs that may significantly affect the performance of the given strategy. They do not take into consideration tax consequences or fees with minimal impact on a given strategy. An investor should understand the impact of transaction costs, margin fees and requirements, and tax considerations before entering into any options strategy.
Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.
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