Options Plays You Can Make Now: From Conservative to Speculative

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 |  Includes: AAPL, AMD, F, RVBD, WMT
by: SA Editor Rocco Pendola

No matter how many articles Seeking Alpha publishes on options - from basic to over everybody's head - readers leave comments and send mail to authors asking questions and looking for clarification. This comes as no surprise. As options go more and more mainstream, mystery and misconception still dogs the retail investor looking to broaden the strategies he or she uses in a portfolio.

In this article, I outline several ways you can use options - now - in any portfolio, ranging from an IRA to a short-term trading account. Alongside each strategy, I provide an actual trade you can make today. Please use these ideas as a starting point for further research, as they are "all things being equal" trades. By this, I mean they ignore your individual circumstances, which I am not privy to, and do not take the volatility that accompanies the meaningful macro events of the day into account.

Conservative

Even the most careful investor would agree that covered call writing is not only a conservative options strategy, but it should be part of most long-term portfolios, such as IRAs.

When you write a covered call, you sell a call against shares of a stock that you own. The party who buys the call you sell purchases the right, but not the obligation, to buy 100 shares of the underlying stock at the option contract's strike price on or before its expiration date. Simply put, if the call holder exercises this right, you must sell him 100 shares of the underlying security at the strike, regardless of market price.

It makes sense to write covered calls against most positions, particularly those with hefty options premiums. Writing calls against dividend-paying stocks enhances the amount of income you receive from the position. If a stock does not pay a dividend, you can create an income stream by writing covered calls. Fellow Seeking Alpha contributor Paul Zimbardo writes articles on a weekly basis showing investors how to squeeze income out of a stake in Apple (NASDAQ:AAPL), for instance.

Wal-Mart (NYSE:WMT) represents a solid stock to write covered calls against. Let's assume you're sitting on 500 shares of WMT that you have owned for several years. While it does pay a dividend, WMT has been a relatively frustrating performer. With shares trading in the neighborhood of $54.00, as of this writing, you could sell five WMT August $55 calls against your position and collect roughly $0.36 for each contract you sell. This income could help ease the sting of the stock's recent lackluster performance, assuming you're not quite ready to give up your shares at market.

No matter what happens, you keep the $180 in option premium ($0.36 by a multiplier of 100 X 5 = $180). If WMT closes below $55 between now and options expiration day, you hang onto your shares. If the stock hits $55, you could get your shares called away. This means you will have to sell them for $55 apiece, regardless of market price. You are more likely to have to part with your shares if WMT approaches, hits or passes the call buyer's breakeven price of $55.36 (call strike price of $55 + the $0.36 option premium paid).

Clearly, as you consider this type of strategy, you need to make sure that you (a) are willing to unload the portion of your position you write calls against (each contract equals 100 shares of the underlying stock) and (b) will be happy with the price you receive, relative to the cost basis on your shares.

Semi-Conservative

Investors often confound options with tools designed exclusively for short-term traders. In reality, options can provide the most conservative, risk-averse investor with strategies to mitigate risk.

Assume you believe a stock has been oversold. You don't think it's going through the roof tomorrow, but over the next year or so, you believe in its prospects. You would love to take a 100 or 1,000-share position, but do not have or do not want to commit the capital to doing so. I own this sentiment in relation to Ford (NYSE:F).

You can use Long-Term Equity AnticiPation Securities (LEAPS) options to make a directional play, but with a smaller capital outlay than you would take on by buying the stock outright. When you buy a LEAPS option, you give yourself the right, but not the obligation, to purchase shares of the underlying stock at the option contract's strike price on or before its expiration date.

As of this writing, with F trading for $13.12, you could purchase the F January 2013 $15 LEAPS call option for $1.47. In this scenario, it costs you $147 to give yourself the right to buy 100 shares of F at $15 per share or before the option contract's expiration day of January 19, 2013. Compare this to buying 100 shares of F today, which would cost more than $1,300. To set yourself up for the possibility of buying 1,000 shares of F (which would cost more than $13,000 today), you could purchase 10 of the aforementioned contracts for $1,470.

And remember, you are under no obligation to exercise the option and buy shares of F. If F increases in value over the next 12 to 16 months, the calls should as well. As they do, you have the option to close out the position by selling the contracts to somebody else for an option premium that is higher than the one you paid. This is akin to buying low and selling a high a stock.

Moderate

Put selling triggers mass confusion and unnecessary concern among investors.

First, you can sell puts of two flavors - cash-secured and naked puts. With the former, you have cash in your account to cover the amount needed to buy a stock if it gets "put" to you. When you sell a naked put, you rely, at least partially, on margin to cover your potential obligation to buy the stock that underlies the put you wrote. Second, and maybe most importantly, your intent and the stock you choose to sell puts on dictates the level of risk you undertake using this strategy.

When you sell a put, you obligate yourself to buy the underlying stock at the option contract's strike price on or before options expiration day, regardless of market price. Clearly, you could get stuck with a stock at a terrible price if it goes into a free fall and all you'll have to show for it is the option premium you collected when you wrote the put.

For example, I would be wary of writing puts on a stock like Riverbed Technology (NASDAQ:RVBD). Had you taken this approach before the stock's recent collapse, you could find yourself in a world of hurt. I am long RVBD via January 2012 calls. For me, this is the appropriate long play on the stock if you are bullish and/or expecting a pull back. Simply put, put selling represents an incredibly risky strategy for stocks that tend toward the type fo drop as RVBD recently exhibited.

If, however, you want to get long a stock that you expect will pullback a bit near-term, while appreciating over the long haul, writing a put in an attempt to go long often represents the best deal. Worst-case scenario, of course, is a major pullback, which is why you have to make sure you're comfortable owning the stock at the strike price you select. Next worst-case scenario - you do not get the pullback you predicted, you miss upward momentum and you either do not get long or you get long at a higher price than you would have otherwise.

Because I think F could be a $20 stock in a year, but could breach $13 in the near-term, I would be comfortable selling a F September $13 put for roughly $0.56. No matter what happens, you keep the option premium of $56. If F breaches $13 between now and options expiration day, you might have to buy 100 shares of F if at contract you sold at $13 apiece, regardless of the stock's market price.

Speculative

Many types of moderate to speculative options strategies exist. I have covered them in past articles and will do so in future Seeking Alpha pieces. One of the most speculative, however, involves buying out-of-the-money calls and puts. Of course, when you buy a call you're generally bullish; when you buy a put, you're typically bearish.

If you believe the price targets and think AAPL will trade at $500 one year from now, buying the AAPL January 2013 $470 calls for roughly $30.00 today (giving yourself a breakeven of $500) represents a relatively speculative bet, at least when compared to going with a deep in-the-money call. That said, you could sell your call to close for a profit as AAPL appreciates without any concern about it hitting lofty price targets.

My recent call on Advanced Micro Devices (NYSE:AMD) was a speculative bet ahead of earnings that just so happened to work out. It still, however, allows investors to put up less money to make a directional play around an event than they would have to put up to buy a stock outright. As with any speculation, you have to prepare yourself to lose all, or at least a significant chunk, of your original investment.

Disclosure: I am long F, RVBD.