How Options Can Conservatively Increase Your Portfolio Returns
When people think of options, the first thing that comes to mind is risk. While options can be used as very speculative investments, they have a place in all portfolios for enhancing returns.
Originally, options were invented as risk hedging instruments for those who owned a specific asset. For example, a farmer might sell an option in order to help him lock in the price for a specific crop that year and to reduce the risk around the uncertainty of weather patterns. However, every contract had different terms, so there was very little trading the market was considered illiquid. To reconcile this, the CBOE standardized options contacts in the 1970s to provide more liquidity in the marketplace. While this introduced some speculation into the marketplace, options were still considered to be financial instruments only suitable to the most sophisticated of investors. Fast forward to the 1990s and the invention of the internet and stock options slowly began to appear in retail investors’ portfolios.
Most portfolios today will have at least some portion allocated to stocks. In order to enter these positions, someone will purchase a stock at the market price and hold until their desired exit point. However, by using options, one can increase the rate of return without introducing any additional risk by using these instruments in the hedging fashion as they were intended.
A cash secured put is when you sell a put below the current stock price with the intention of purchasing the stock if it is at that price at the contract expiration. These puts pay the seller a premium which can add to their overall return. Similarly, a covered call is when you sell a call above the current stock price with the intention of selling the stock if it reaches that price. These calls pay the seller a premium which can also be added to their overall return. Let’s illustrate this with an example.
Let’s assume Apple is trading at $100 per share. I would like to own Apple at this price. Instead of buying the stock outright, I can sell 1 put contract 1 month into the future for $3. Therefore, I currently just pocketed $300 by selling this contract (since all equity options contracts control 100 shares). What this means is that if Apple is below $100 in one month, I am obligated to purchase 100 shares of Apple at $100 each. Alternatively, if Apple is trading above $100 per share in 1 month, I keep the $300 I sold the option for making 3% on my money in 30 days.
Similarly, if I own 100 shares of Apple stock at $100 per share and I would like to sell, I can sell a covered call. If the call option is trading at $3 per contract, I can sell one contract for 30 days out and pocket $300. After a month, if Apple is trading above $100 per share, I am obligated to sell the stock at $100. If Apple is trading below $100 per share, I keep the money from the covered call and can do it again for the following month.
One important thing to note is that doing this strategy allows you to lock in returns and widen break even points. Therefore, these strategies reduce the overall risk in your portfolio.
But how much of a difference can these small premiums make. Let’s consider two portfolios: one that receives an 8% return annually by investing in stocks and one that receives the same 8% return annually but also enters and exits positions by selling cash secured puts and covered calls. If your account begins with $10,000, 8% annual return compounded monthly will leave you with $242,733.86 after 40 years. By properly utilizing cash secured puts and covered calls, a portfolio can increase its return from 8% to 10% by adding these additional premiums to their bankroll in exchange for setting their entry and exit points ahead of time. In the second portfolio, you would have $537,006.63 after 40 years. Now that’s a massive difference!
In conclusion, options are not just instruments for speculators and those with high-risk tolerances. Deployed effectively, these instruments can have a tremendous impact on the portfolio of the average investor.