Options Philosophy Of A Dividend Stock Investor

 

After reflecting somewhat on options, and trying to decide what the appropriate approach to utilizing options should be for a dividend stock investor, I have written out my conclusions on the topic. To define the subject, I am talking about options on stocks, primarily, although options on stock indexes are also relevant to the conversation. First, let me say that I am fascinated by options. When I first began trading/investing full-time after retirement, I investigated options extensively, reading book after book. As I learned more, I began cautiously experimenting with various strategies. What I learned was that there is no guaranteed options trade. Just as with any trade or investment, an options trade is a wager on the future. The unique thing about options is that you can make a bet that will prosper if the underlying stock or index (simply referred to as the “underlying”, in options talk) goes up, you can make a bet that will prosper if the underlying stock or index goes down, and you can even make a bet that will prosper if the underlying stock or index goes nowhere. Further, using various spread and spread combination strategies, you can define with some precision how much risk (of loss) you want to take, and weigh that against the potential gain. Going into the topic even deeper, you can review the option “greeks” of a particular option, the historical volatility of the underlying, and calculate a theoretical option price using various values of anticipated future volatility (implied volatility, in options talk). Then, you can compare the calculated price to the available option price quotes, to determine if an option quoted is a “good deal” or not. To do all of these things, you must enter the world of option spreads, straddles, strangles, butterfly spreads, condor spreads, iron condor spreads, calendar spreads, volatility spreads, collars, option "greeks" (delta, gamma, vega, theta, and rho), Black-Scholes option pricing model calculator, or other options calculators, and much more that I have not mentioned. To wrap this all up, I will simply say that I learned a lot, but my results were modest for the effort expended. Like much in life, to be successful trading options requires an intense focus. I found that it would be very difficult to give my options trading the required attention without neglecting what I wanted to be my primary focus, locating and evaluating dividend-paying stocks, to be acquired as long-term investments.

That takes me to where I am today with options. I do not usually consider taking a position on a stock solely on the basis of options availability, with the intent of entering a stock position and an options position simultaneously, or in close proximity time-wise. I also usually do not enter an option-only position, either a simple call or put, or some type of spread. I primarily use options as an auxiliary, add-on strategy to “juice” returns. I only sell options, so time decay is always on my side. To limit risk, I only enter “covered” call sales, or put sales “covered” by cash. Note that I do not consider a put sale as a contradiction to the statement above that I do not enter option-only positions. I view a put sale as a conditional buy order, just as I consider a call sale as a conditional sell order. Now I will explain when (under my approach) these option positions should be considered. A call sale is viable if the market over-all has been rising and seems to be up to at least an interim high, I have a stock that has enjoyed a nice run-up, and I can sell an option at a strike that is above the current price that would be an attractive selling price, yielding a gain I would be happy to take. Further, the option sale price is at least $1.00 or more. Conversely, a put sale is viable if the market over-all has been declining and seems to be down to at least an interim low, there is a stock I would like to own that has come down along with the market, but is still not as low as I would prefer to buy it at. If a put can be sold that has a strike low enough that I would be a buyer at that price, and the option price is reasonable - $2.00 to $3.00 – I will consider a put sale. I require a little more here than in the case of a call sale, since this strategy ties up capital, and is perceived (by me, at least) to be higher risk.

Now, a further word of caution. Don’t get carried away, with calls sold against nearly all stock positions. The covered call selling strategy should be selective, only on stocks that one is willing to sell. Keep in mind that the call sale proceeds received is not a lot of money – if the stock shoots up beyond all expectation, you will end up sacrificing a significant gain in exchange for what will seem like a paltry sum that was received from the option sale. The put selling strategy should be used even more selectively. Even though you maintain cash balances adequate to meet all put assignments, if an unexpected (is there any other kind?) market decline occurs, maybe even a crash, you can end up with all of your cash being used up to buy the stocks that you had sold puts on. Further, the prices paid, which were once thought to be somewhat attractive, might be well above the market at the time of assignment, which is definitely not attractive when buying stock. Further, if most of your cash is expended honoring these put contracts, you will not have funds available to take advantage of the many buy opportunities that will suddenly be appearing as the decline gathers steam.

 That sums up the options philosophy that I have incorporated into my overall approach to investing.