Retirement: A Beginner's Guide On Basic Option Strategies (Part 5)

Includes: GE, JNJ, MSFT, PG, XOM
by: Regarded Solutions

One of the really neat benefits to building a solid portfolio of core stocks for any future plans you have, is that while you are building and growing, you can also generate even more cash to use to build your portfolio faster and stronger.

The beginners portfolio we have been working with is as follows:

  • General Electric (NYSE:GE)
  • Exxon Mobil (NYSE:XOM)
  • Proctor & Gamble (NYSE:PG)
  • Johnson and Johnson (NYSE:JNJ)
  • Microsoft (NASDAQ:MSFT)

Assuming that you have established your core positions in each stock we can move into the next phase of investing which at first glance can be confusing, but actually is a relatively easy and low risk strategy.

Using Options To Build Cash

There are 2 rather simple strategies that I will outline in this chapter for you to gain a feel for each, and hopefully explore them further.

  • Selling covered call options on stocks you already own
  • Selling put options on stocks you want to buy at the price you want to pay

Selling Covered Calls

On each of the stocks in this portfolio there is an options chart. On the chart are a list of available options that you can sell against your current positions at a higher strike price than what you initially paid for the shares.

For example, lets say you wanted to sell calls against your XOM position and you own 300 shares purchased at $80.00/share. Look at the chart of call options for a strike price over $80.00 with an expiration date of July 21st.

In a market such as this, we have seen a decline in oil prices and some weakening in the energy stocks, so you decide that you would like to sell your shares if the price hits $85.00 but prefer not to. You can sell the options against your 300 shares with 3 contracts (1 contract equals 100 shares) and collect the premium which for arguments sake is $1.00/share.

By agreeing to sell your 300 shares of XOM at $85.00, you will immediately pocket $300 by selling those options. On July 21st, if the share price of XOM is $84.00, the options you sold will expire, you will still keep the shares and you have already pocketed the premium of $300.

If the share price is $86.00, your shares will be sold automatically at $85.00, you will have made a profit of $5.00/share on the stock, and you also get to keep the initial premium paid to you of $300.00.

The upside is that you can make money and still keep your shares and the risk is that you can have your shares automatically sold and potentially miss out on a strong upside move above your strike price.

Now, remember what your goal is. Building a portfolio of core stocks and healthy cash reserves to grow the value of your portfolio over the long term. Not 6 months, but 10,20,30 years or longer.

If the stock is sold, you can buy it back the very next day, or wait for a pullback in price before you do. If the stock drops in price you really are not very concerned because the blue chip stocks you own always seem to make a comeback, and/or continue to pay you dividends to reinvest anyway. That will further grow your portfolio value over time anyway.

One more thing about selling covered calls. If the options expire and you still own the shares, you can do the process over again with the next month on the option chain of each stock.

In effect, you can generate a monthly or semi monthly cash flow that can be used to continue to build your portfolio and enhance your overall yield.

Selling Put Options

The other basic option strategy that has low risk is selling put options to actually buy shares of a stock you want to own, or to add to a position you already have.

Let's assume that you want to add 500 shares of GE to your existing position. You feel that the market still faces some headwinds in Europe and the share price of GE might drop and you feel strongly that the company has a very bright future and adding shares at a bargain price will benefit you in the long run.

Instead of just putting a limit order in at the price you want to buy the shares, take a look at the "put" side of the options chart for GE. You have decided that adding more GE at $17.00/share is where you want to be. Lets say the put price for the July 21st expiration is $.30/share. By selling 5 contracts you will immediately pocket $150.00 in cash, and have the opportunity to buy the shares of GE if the price is at or below $17.00 by the time the options expire.

If the share price rises from here, or stays flat, the options will expire, you will not own more shares but you keep the $150.00 premium. If the price drops to $17.00 on that expiration date you will automatically buy the 500 shares at the price you have decided on ($17.00) and you still keep the $150 premium you received upfront.

The risks are that if you do not truly want to own more shares, and use this strategy, you will. I recommend that you do this only with stock you really want to own or add to positions already owned. Another risk is that the share price could wind up being lower than the $17.00 price you decided on and you will pay more for the shares than the price shown. That will more than likely be a temporary issue since this is a long term strategy and the big blue chip stocks you're working with tend to come back in price, plus you will be getting even more dividends and cash flow from this transaction to smooth out some bumps.

The other issue when selling puts, is that you will need to have the cash available to complete the purchase of the shares when you actually implement the trade. So at $17.00/share for 500 shares, your broker will set aside $8,500 from your cash position to pay for the possible purchase. Of course if you were contemplating buying this much you would have needed to have the cash anyway (or margin) to cover the purchase so this is NOT as "cruel" as it might first seem. If you do not get the shares, the cash is "freed up" and you can do this trade all over again in the following months. Once again, this strategy can give you cash flow as well as an opportunity to own the shares you want at a price you want and get paid to wait it out.

My Opinion

These two basic option strategies are the most widely used, and the easiest to grasp. Make sure your brokerage account is set up to allow these trades, and you might have to sign some papers saying that you understand this level of option trades.

By implementing both of these strategies, a beginner can get a feel of how powerful options can be to augment and supplement your overall portfolio, and by not taking on excessive risks, you can feel pretty good about making these trades.

They also do act as a small hedge against falling prices because the money you receive in premiums can also be deducted from your cost basis on each particular stock you use this strategy with, but the main focus is to make more money and do it for the long term success of investing.

More to come: Mutual Funds, ETFs or Individual Stocks, Which are Best For You

Disclosure: I am long XOM, GE, JNJ, PG.