Option trading volume doubled during the COVID years, as speculators (often referred to as investors) turned to any available speculative medium. If stocks are considered a gambling medium — and they certainly can be used that way — then options can be a gambling medium on steroids. However, they can also be used as an investment medium. Surprisingly, option trading volume continued to grow even as the COVID speculative era subsided in 2022.
My opinion is that options should only be considered after significant and successful experience with stocks, including a vicious bear market.
Volatility is commonly confused with risk. Options can be used to reduce risk, but are also likely to increase volatility. Bear market experience is important, because we must understand our own reactions to volatility. Do we hold or fold?
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With that brief cautionary introduction out of the way, I will now attempt to explain how I’ve used options in combination with stocks to enhance portfolio performance to achieve the 18 per cent annual growth rate in the taxable (former newsletter) account.
Most of my option investments are the sale of puts, which gives someone the right to sell me (put to me) the stock at a specified price before a specified date. I get a premium for doing this, which is my return for taking the risk if the price of the stock goes down. For example, if a stock is $100, I will often sell a put with expiration from six to 18 months into the future. I will usually get about 10 per cent or about 10 bucks per share for doing this. A contract is 100 shares, so this will be about $1,000. I do this only if I am positive on a stock, while the person buying the put is negative on the stock and is looking for downside risk protection.
If the price of the stock stays flat or goes up, I keep the premium. If it goes down, I must pay $100 per share but subtracting the premium, it really costs me $90. If I’m positive on the stock and willing to pay $100, I’m generally happy getting it for 10 bucks less — although if the share price goes down a lot, I’m not happy! When selling a put, I go through the same financial analysis as any stock I buy, because I could end up owning it. I often sell puts on companies I already own, attempting to pick up extra shares on the cheap.
That’s a brief explanation, but for better understanding if you are unfamiliar with options, there is lots of information on the web.
‘Market insurance’
Over the decade of the newsletter account, I sold a total of 122 contracts on many different companies. Sixty-four contracts expired and I bought out 31 contracts profitably for a total of 95/122, or a 78 per cent win rate. That’s a good batting average. I bought out five contracts at a loss and was put the shares 22 times. However, of the 22 times I was put, I either sold the shares profitably or am still holding the shares in a profit position 10 times, which brings my win rate up to 105/122 or 86 per cent. I didn’t add up all the profits from this effort, but it has made a substantial contribution to the portfolio performance.
Selling puts uses margin and can only be done in a taxable account. It is easy to get over your skis with the strategy, so I keep a keen eye on my overall margin level to guard against face-planting. I also never enter into contracts where the underlying value of the stocks in the contract is larger than the normal position size in the portfolio. I always try to get a 10 to 12 per cent option premium, which gives me a 10-12 per cent discount on the shares if I get put.
The second way I use options is purchasing S&P 500 (SPY) puts. I refer to this as market insurance. If the market drops quickly, the value of the puts goes up. Insurance costs money, but provides a cushion during market corrections or bear markets. I started doing this late in 2021 when the market looked very speculative, which paid off during the 2022 bear market. It also worked during the tariff panic last spring. So far, I have closed out 13 such contracts at losses and six for profits. One of the key hedging benefits is that during drawdowns, selling the contracts provides cash for the possibility of getting put some of the stocks as described above, or picking up other shares at better pricing. When totaling all these contracts to date, I was surprised how little money I have lost on the insurance. I have six such contracts in place right now as I am concerned about current market levels.
The third way I use options is in selling covered calls. A call is the right for someone to buy (call) the stock from you at a specified price prior to a specified date. A covered call means you own the underlying stock. While many tout this as an income strategy, I see it as another downside hedge strategy. I believe if you routinely sell covered calls you will experience a lot of portfolio turnover and reduce overall portfolio appreciation. I only sell covered calls on stocks I think are overvalued at the time.
Counting the results from the covered calls I have sold, I had nine contracts that either expired or were bought out at a profit and only one I bought out at a loss. I was surprised at how much I made cumulatively. Overall, I have made about double what I lost on the insurance puts. The only real negative is that four times I had the shares called from me. They all have gone on to do very well after I sold. But I only sold covered calls when I thought the stock was overvalued, so I can’t be too disappointed in this outcome.
Combining stock and option strategies has definitely enhanced returns. The proof is in the pudding!
