Options have the unfortunate reputation of being risky. I hope to dispel that notion today.
music selection: “Sacred Heart” — Dio
While it is true that a Lizard can shoot himself in the foot by applying excessive options leverage, that is not the Raptor Way. Raptors mostly write (sell) options so that the premium income acts as a hedge. But it works when buying options as well.
For example, here at the Raptor we often short UVXY. We do not enter a direct short sale against the shares however. See, a direct short has potentially unlimited downside risk. You lose money as the share price rises and it can theoretically keep going up forever. You could lose more than you invested in the first place! But by buying a put option, we limit our downside risk to the put premium. The lowest our new asset can go is zero. That is much better than an infinite risk profile. A wise raptor also keeps his position size reasonable so in the unlikely event the put expires worthless, there is capital remaining to trade another day.
Most of what I do here at the Raptor is to sell put options. The options premium is an automatic hedge on the trade. Say JNJ is trading at 100.27 (like today!) You might sell JNJ150918P00100000 for 1.80 a contract. You put 180 bucks in your brokerage account immediately. You are on the hook to buy JNJ at a discount to today’s price at 100 even if the price is lower at the time of expiration in mid September. So, there is no risk until JNJ delcines at least 27 cents (almost a third of a percent) and you don’t lose money on the trade until JNJ declines an *additional* 1.80 (your premium income). Put another way, if JNJ closes on 18SEP15 at 98.20, you broke even. Even though the price declined 2.06%. So selling a put is 2.06% safer than just buying JNJ outright at today’s price.
It works on covered calls as well. Say you already own JNJ with a purchase price of 100 (you made about 18% annualized return writing a put at 100 a few months ago). The raptor way would be to go about 10% out of the money to around 110 JNJ150918C00110000 for about 3 cents a contract. Over the 50 days the trade is open, you earn about .22% annualized return. This doesn’t sound like much but your total take of dividend plus premium is about 7.3% higher than if you were just collecting the dividend. Plenty of people do dividend growth investing exclusively and leave this obvious bonus on the table! Your risk? Previously, you began to lose money on the trade at 100 dollars even. You now have 3 cents extra wiggle room. And if you don’t get called, you’ll collect another 3 cents or so (now you are at 6 cents downside protection) for the next 50 days or so your new call is active. And your “downside” is selling JNJ at an elevated price 110. That would be a 10% gain over 50 days or 73% annualized return. A lizard will not grow broke using *that* strategy!
So you see, if you use options strategically, you can limit your risk. Shorts no longer have unlimited downside and long positions come with a hedge in the amount of your premium income. You took on less risk that conventional investors and earned a higher return while doing it.
Devour your prey raptors!