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Playing Defense
With the market off to a rough start so far in 2005, we'd like to respond to a request we've received plenty of times recently. A reader asks "I know the market fluctuates, but it seems like the fluctuations eat away at all the gains I may have had before the market dipped. I own good quality stocks, but is there a way to minimize the effect of the pullbacks without just selling out of stocks? It seems like my defensive selling occurs right before the market rallies back. Is there something else I can do?" The answer is yes, there are some techniques you can use. 1. Buy a put option.
While most of you may be well versed in options, let's just start at the very beginning. There are two basic types of stock options. A 'call' option gives you the right to buy a stock at a certain price within a certain period of time. A 'put' option gives you the right to sell a stock at a certain price within a certain period of time. For instance, a Microsoft February 30 put option gives you the right to sell 100 shares (one put option controls 100 shares of the underlying stock) of Microsoft at 30 dollars per share until the option expires in February. You don't even have to own 100 shares of the underlying stock to buy the put option. Remember, you're the one buying the put option, so you're the one who can choose to exercise the option. Of course, nothing is free. If you want to buy the put, you'll have to pay for it. Currently Microsoft is trading at 27.40. So, the February 30 put is inherently worth 2.60 per share (or a grand total of $260). However, you'd have to pay about 2.80 for the Microsoft February 30 put right now. That extra 20 cents is just the premium you have to pay for having the right to choose.
The point? Think about this. If your 100 shares of Microsoft fall from 27.40 to 25.00, then you'll have lost $240. But, the February 30 put will have gained $240 in value. The two positions offset each other. You may not have gained, but you'll certainly not have lost. If instead, shares of Microsoft go to 31.50, then the put option (the right to sell them at 30) would be worthless. But that wouldn't be all bad - you'll have lost the whole $240 you paid for the put option, but you'll have gained $410 on your 100 shares. The downside? There's a time limit on this option. You're hedged until February's option expiration, then you'll either have to sell the option and take the profit, or it will expire. Either way, you're back to just owning the 100 shares. But at least the downturn wouldn't have hurt your portfolio's value during that time. 2. Sell a covered call. The other option is to sell a covered call. This strategy is a bit more complex, so let's start at the beginning. Remember from the example above how we bought the Microsoft 30 put? We were looking to buy it at a low price, then sell it later at a higher price (if Microsoft shares did indeed go down in value). It's the old "buy low - sell high" rule. But it's not the only way of doing it. You can also sell high, then buy low....or even not buy at all.
If the put option gains in value as Microsoft shares decline, then a call option would decline in value as Microsoft falls. For instance, if Microsoft shares are at 27.40, then the February 25 call is worth $240 (or 2.40 per share). How much is the February 25 call worth if Microsoft falls to 24.30? Well, basically nothing - who'd want to buy shares at 25 each when they can buy them in the open market for 24.30? In a case such as this, we'd look to sell the call at the higher price, then buy it back later at a lower price, or better yet, let it expire worthless without even needing to buy it back. Why would this be any better than just buying a put? Two reasons. First, remember the extra 20 cents we had to pay as premium to buy the put. Rather than pay it, why not receive it? It may only be 20 cents, but in this case, it represents almost an extra 10 percent worth of gain on the option trade. Second, you save big on commissions. Option trades aren't exactly cheap to begin with. If you have to pay commissions to buy one, then sell it later, it can really eat at profits. If instead you can sell an option and then never have to buy it back, you'll cut your commission costs in half. Is there a downside? Potentially. When you're buying an option, you're in control of whether or not you exercise the option. When you sell an option though, you're selling someone else the right to exercise the option against you. This is where the term 'covered call' comes in. If you're selling a covered call, that means you have 100 shares of the underlying stock to 'cover' the option in case the buyer of the call option decides he wants your shares. For example, if Microsoft shares go to 29.20 (or any price above 25.00), then the call you sold will be exercised against you, and you'll have to sell your Microsoft shares at 25.00. Again, it's not all bad. You'll have missed out on 4.20 worth of gain, but you'll have at least pocketed the $250 from selling the call. On the surface that may not seem like a great proposition, but there are two huge benefits to selling covered calls. First, it puts real cash into your account right now - actual dollars. Second, if you originally paid 14.00 for Microsoft shares, you still netted $1100 (plus the $250 on the option trade). So, those are two basic strategies to help overcome market pullbacks. The first one puts you in control, and you don't have to own any shares of the underlying stock. The downside of the put-buying strategy is that you'll (hopefully) have to pay commissions twice, and you'll have to pay a little extra premium up front. The covered call strategy, on the other hand, gives someone else control. You'll need at least 100 shares of the underlying stock. However, the potential returns on these option trades are greater, if you don't mind selling your shares on occasion. Look at it like this - if you have 100 shares of a stock you were going to sell anyway, then selling covered calls is a nice way to try and generate a little more income before liquidating the position. It's the optimal way to own long-term, high-quality stocks but take advantage of short-term market downturns.
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