Today’s article is a departure from my regular articles on the myths about money. Our portfolio manager has been using a strategy of puts and calls to enhance the performance of our investments and increase our income. You will not get any details on how to do this for yourself because this will be an educational email only and I will speak in general and over-simplified terms.
You may have noticed from the general press that the stock market has been acting crazy, much like the people involved in it day-to-day. This volatility is often caused by computer trading, and it also allows for opportunities for the individual investor or portfolio manager to take advantage of small price changes by using options.
What is an option?
An option is like a contract between a buyer and a seller of something. As an example, it allows someone to pay a small premium for the right to purchase something in the future at a price set in advance. This basic concept can be used in many areas from buying a business or real estate to a stock.
In real estate, a lease-option would allow you to lease a house at a certain price with the option to purchase the home at a later date at a price agreed to in advance. Often an expiration date will be included. Your lease payment might include an extra amount for the option fee, or some of the lease payment might even count toward the purchase price. All of that would be spelled out in the contract.
If the house rises in value beyond the price agreed to, it becomes a profit for you if and when you choose to exercise the option and buy the house. If the house drops in value, you do not have to exercise your option and the option fee would become additional income to the seller of the option.
What are put and call options?
These terms refer to stock (marketable securities) options trading.
A put option provides the right to sell at a specific price (the strike price) until a certain date (the expiration). The expiration date could be a month away, a day away, or even an hour later. If I think a stock is going to go down in value, I would want to buy the put option from someone else who thinks the stock is going to go up in value.
Think of it as my right to put or push the stock onto the seller of that option. When the put option expires unexercised, the seller keeps the premium paid as his or her income without any further obligation to purchase the stock.
A call option is just the reverse. You pay a fee, called the premium, to purchase the right to buy a stock at a certain price by a certain date. If I think a stock is going to go up in value I would purchase a call from someone who thinks the stock is going to go down in value.
If you want a more detailed explanation (or you want to learn about naked options trading) just Google those terms.
It’s important to know that all stock options, as well as various other of the stock market’s so-called derivative instruments, like commodity futures, are extremely risky investments. In the movie Trading Places (1983) with Eddie Murphy, Dan Aykroyd, Jamie Lee Curtis, Don Ameche, and Ralph Bellamy the poor traded places with the wealthy over a bad investment bet and fortunes were lost. While that was based on future contracts, similar results can happen when trading options.
Additional income can be earned for a stock portfolio with detailed research and by selling puts and calls. This is certainly not something to be pursued by the faint of heart; if we lost tens of thousands of dollars in our portfolio from a bad bet it would not change our standard of living. We don’t even use that money for support. It’s the income from our real estate that pays for our standard of living.
Hopefully, you now have an idea of the different ways you can play the market, instead of just investing in stocks. Just like playing blackjack in Las Vegas this is not about investing; this is about playing the market.
To Your Prosperity,
Rennie
