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Options. This word seems to evoke fear and revulsion among the investors I personally know (not so many) and is apparently the opposite type of investment that any truly conservative investor would utilize from what I've read through other blogs or inferred from the complete lack of coverage. I've been studying them in depth over the past month, familiarizing myself with their vocabulary (for example who knew you could be long and short at the same time??) and attempting to wrap my head around what makes them so great? Are options really that dangerous for investors?

Now I am only just beginning to learn more about the world of investing. In college I sat down and took a cursory glance through, including some basic reading on options, however I still hadn't completely wrapped my head around the basic fundamental analysis involved in analyzing companies and stocks. Recently I sat down and brushed up on my basic accounting, which suddenly unlocked the world of balance sheets for me (something I never quite understood before in spite of graduating with a degree in business). Once I realized the importance of balance sheets and the logic behind them, I began diving into stocks. Of course, not having enough money to buy stocks outright is something of an issue. This, in conjunction with one of my best friend's undertaking a study of exclusively option based strategies led me back to options for the second time. 

This time, armed with the ability to guess at a stock's approximate value slightly more intelligently than before and retaining some of my cursory self-studies into the world of options from the past, it made a lot more sense to me. I realized that there are two sides to an option trade. One person is buying the option and the other is selling. How exactly did a person sell options? If you sold options, did you need to own the stocks you were selling options for? How could this be combined with my personal goals to build a dividend portfolio and would this still be compatible with a conservative investing style?

Looking at the basic format of a short Put option (this means you sold the Put option to someone else), it is essentially a contract stating that you will purchase 100 shares of company XYZ at strike price $XX.XX if the price decreases below this strike price by an agreed upon date. Now, typically people that write options are portrayed as not wanting the contract to be assigned, preferring to keep the premium the buyer pays them for the contract without having to buy the shares upon or prior to expiration. But what if I were to flip this around and use a put option to secure my desired entry point for 100 shares in a company which I had already thoroughly researched and determined worthy of adding to my portfolio? 

In this case, I would be paid to purchase the company I wanted to buy anyway! For example, lets say I want to buy shares in Coca Cola (I actually really, really want to!). It is trading for approximately $40.70 today, but I would be much more comfortable purchasing it for less than $40. I could just put in a limit order and wait for it to drop to that price and buy it. Or I could sell a May 15, strike price $40 put option, collect $55 and wait for the price to drop or the option to expire. If the price does not drop by the time the option expires the following month, I can simply repeat this procedure the following month. If I do get assigned, I pay $3,945, which works out to be $39.45/share. The longer it takes for the shares to drop to my preferred entry price, the more I would make off of the underlying security and the less they will eventually cost me when I do get assigned. It is almost like earning dividends without even owning the stock! Basically you are serving as the stock "insurance agent" for that particular security. To determine if this strategy is viable I began digging into the ins and outs of selling options.

I found a cool book called "Options for the Conservative Investor" by Michael C. Thomsett which relates several key strategies where options can substantially boost a portfolio's performance and hedge against losses during market downturns. This book validated my original hypothesis and vastly expanded my primitive understanding on the use options. I learned about covered call writing, which can be used by folks that already own a stock to generate cash flow from their stocks during horizontal markets and used to offset the cost of purchasing a long put, which would insure the value of your holdings from short term price fluctuations.

Based off of this initial research, I have drawn the conclusion that, utilized systematically with a deliberate plan and careful analysis, a conservative investor will benefit from the usage of options within their portfolio, if only to hedge against concerns about the future of the market and secure desirable entry prices for stocks that they would like to add to their portfolio. I am now preparing to test this strategy with my own first options transaction, presently having transferred the appropriate cash to my portfolio to cover the put transaction costs.

If this initial strategy proves feasible in actual practice, I will then begin looking into the implementation of a second tier of strategy which will maximize cash flow from my portfolio, which being super tiny presently, definitely requires some serious growth. Unfortunately, due to my personal credit card debt, I will be unable to invest in the portfolio routinely as most of my expendable cash will be going into debt repayment for the duration of the year. Therefore any cash I invest will have to be generated by my portfolio rather than by me. Hence my focus on identifying assets that provide dividends and cash flow. Stay posted for the results of this first tier of my options cash flow strategy, which I will be putting up sometime next week. 
 


Comments

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04/25/2016 1:37am

Very useful knowledge you shared on option segment, usually i trade in equity segment but after reading this great blog i will go for option segment also.

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06/06/2016 2:30am

I would like to read more blog posts on this blog and also share it. to my friends.

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07/13/2016 3:39am

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