Using Options As Investments In Long-Term Portfolios

by: SA Editor Rocco Pendola

More than any other query, Seeking Alpha readers wrote me in 2011 asking for basic information on options. Routinely, I would send them to four sources:

  • And the websites of the Chicago Board Options Exchange (CBOE) and the Options Industry Council.

Four better sources on options do not exist. I owe most of what I know about the subject to Weinstein and Ruffy. Even still, I continued to get emails, often repeat correspondence, asking for one place that covers nothing but the very basics. The most important things I think an investor needs to know to get started with options. This led me to the idea of writing and publishing a basic options eBook.

The $10,000 portfolio that I trade in and track on Seeking Alpha looks more like a long-term investor's portfolio as it stands for 2012 than it did throughout 2011 when I tripled it. Remember, last year's iteration focused on bearish Netflix (NASDAQ:NFLX) and Research In Motion (RIMM) plays. I like things as they stand now, not only because I like keeping things fresh, but also because the $10,000 portfolio now more accurately reflects my real-life holdings.

In this article, I look at the holdings and discuss ways that the portfolio uses (or could use) options in a way that most closely resembles direct stock ownership. Going forward, I will also use options in conjunction with the portfolio's core holdings.

First, here's a review of the performance of the portfolio's core as well as its one current option play, as of Wednesday's market close:

Company (Ticker) Lump-Sum Investment Lump-Sum Price (Shares) Closing Value/Price 01/04/2012 % Change
American Electric Power (NYSE:AEP) $6,000 $39.70 (151.1) $6,180/$40.90 3.0
HCP, Inc. (NYSE:HCP) $6,000 $39.35 (152.5) $6,155/$40.36 2.6
Rogers Communications (NYSE:RCI) $6,000 $36.91 (162.6) $6,237/$38.36 4.0
Verizon Communications (NYSE:VZ) $6,000 $39.04 (153.7) $6,027/$39.21 0.5

In the $10,000 portfolio, I am comparing the use of three different call options to play previously-anticipated, now-realized upside in Apple (NASDAQ:AAPL).

Option Contract Investment/(# Of Contracts Value/% Change, As Of Close, 01/04/2012
AAPL Jan 2012 $380 Calls $8,492 (4) $13,720 / 61.6%
AAPL Feb 2012 $380 Calls $8,310 (3) $12,030 / 44.8%
AAPL July 2012 $395 Calls $8,110 (2) $9,950 / 22.7%

AAPL closed Wednesday's session at $413.44. Obviously, the calls are working out well. The first two, which I now have to manage, were nothing more than short-term speculative option trades that worked out. At this point, it's prudent to close both positions.

Taken together with the total value of the core holdings ($24,599), the $10,000 portfolio sports a value of $38,319 using the proceeds from the January calls or a value of $36,629 based on the proceeds from the February calls.

I bought the July 2012 $395 calls while they were out-of-the-money. These calls come closer to representing a stock investment than the shorter-term trades. However, if you really want to come as close as possible to replicating stock ownership via options, you would need to go with something that actually moves in relative lock-step with the stock. Something more like a deeper in-the-money call with a delta closer to 1.0.

In any event, I will use the July 2012 calls to figure the running tally of the $10,000 portfolio. The $9,950 on-paper profit puts it at $34,549.

Looking back to the core holdings, there might not be a better options strategy for relatively conservative long-term investors than covered calls. Each of the $10,000 portfolio's core holdings represent solid stocks to write covered calls on. They help enhance income generation, working alongside the dividend each stock pays.

Because I can only write one contract per holding, the income is relatively puny (and not worth the trade, unless you have ultra-low commissions). But, as this strategy plays out, it should illustrate the power of combining dividend income with covered call income on what amounts to moderate-growth stocks.

Here are the covered calls I am writing on each core holding, using Wednesday's closing bid prices:

  • AEP February $42 call @ $0.30. Credit: $30.
  • HCP April $45 call @ $0.40. Credit: $40.
  • RCI Nothing at the moment. Thinly-traded options.
  • VZ February $41 call @ $0.19. Credit: $19.

With $89 in additional income, the value of the $10,000 portfolio, as of Wednesday's close, stands at $34,638.

Because you can repeat the process by writing new covered calls when the existing ones expire, I consider this a long-term strategy, particularly when coupled with dividend reinvestment. Of course, I run the risk of having 100 of my shares in AEP, HCP or VZ called away, but if that happens I am guaranteed a meaningful profit.

If any of this discussion about options does not make sense to you, then you would most likely get some value out of my options eBook.

It's also important to note that, as a corollary to the lump-sum investments in the $10,000 portfolio's core holdings, I am also dollar cost averaging into each stock at the rate of $500 a month. The next scheduled investment happens on or around the 20th of the month. Ultimately, I want to compare the results between the two methods.

Early on, returns could suffer. As I dollar cost average, I restrict dividend income considerably (though I reinvest the dividends I do receive). I also prohibit myself from writing covered calls. It will be interesting to see how it plays out over time.

In the next installment of the $10,000 portfolio, I look closer at dollar cost averaging, as I make the next buys at the core. I will likely unload AAPL as well ahead of earnings, just to play it safe. But, I'll take the proceeds and likely plow them into something even more speculative.

Disclosure: I am long AAPL, AEP, HCP, VZ.

Additional disclosure: I am long NFLX June $40 put options. I intend to open a long position in RCI in an IRA later this month.