About 15 years ago I began buying options several times a month with the idea of making lots of money. Several years later the tech bubble burst, and with it my profits from option trading. I had learned very little, and concluded that the stock market was mostly a game of chance. I stayed away for the next 9 years. As my profile notes, my focus now is on high-yielding stocks and other entities, which overlaps somewhat with Dividend Growth Investing - that is, some high yielders (greater than 6 percent) do grow their dividends/distributions.
But I've never forgotten the tools that options in combination with stocks bring to the investing table - yes investing. For example if you fear a sharp market drop in the next several months, buying a put option on the S&P 500 that expires in several months can protect from a market drop while you keep your portfolio intact. It's like buying insurance. This is the opposite of risk-taking - it's hedging.
Is there a way to use options to increase your gain in the following situation? You've got a winner on your hands. In fact, it's grown too much for your portfolio to handle. You need to diversify by selling some or all of it. The recent gain of AT&T (NYSE:T) might be causing some to consider this. It hasn't been this high since mid-June 2008 and it's run up 30 percent since Thanksgiving. The dividend now is under 5 percent. So you're ready to place a limit order somewhere above the current price and wait until T gets there.
Instead of that, sell an option on T at the price you're willing to sell. Each option represents 100 shares, so if you own 370 shares, you could sell three-and no more than 3-options on your holding. If you're willing to part with T at a price of $36, an option with a strike price of $36 expiring on July 20 sold for $37 per hundred at the close last Friday. That's over a one percent gain in 5 weeks time, and I'm not including the price increase of the stock itself, because you would receive that anyway with your limit order. If T is not at $36 on July 20th, you keep the option premium, you still have your shares, the option expires, and you can repeat the process for the August option expiration if you want. If T is at 36 or more, your stock will be called away and you'll receive $36 a share, the same as you would have with a limit order.
If instead you want to wait until T reaches 37, that option will only bring you nine dollars per hundred shares based on Friday's close, which after commissions of about $12 wouldn't bring in much unless you have thousands of shares.
Another example is Altria (NYSE:MO). At Friday's close, it was trading at a post split high of 33.77. Maybe your portfolio needs diversification. It's dividend now is also under 5 percent. If you were planning to place a limit order to sell at 34, you could instead sell a call with a 34 strike price expiring on July 20th for $48. Remember one option equals 100 shares, so 550 shares would allow for five, and only five options. If you wanted to sell only 300 shares at the limit price, then only sell three options. This option premium is a 1.4 percent return in five weeks time. If the price doesn't reach 34 by July 20th, you keep the option premium, keep the shares, and the option expires.
What if the stock price rises above the strike price before expiration and then falls back below the strike price at expiration? In all likelihood, your stock would not be called away, and on July 20th you would still own the stock. You keep the premium. This result, of course, is a different one from placing a limit order.
Whipsaws are the worst case scenario. They are the bane of option sellers in this situation. Let's say your stock price increases above the price you want to sell before July 20th, but then it falls back and never reaches that price again. You would have lost the chance to sell at the price you want. On the other hand, you have your option premium and you could sell options on your stock for the next month.
Long T and I may sell an option on my shares within the next 72 hours.
Disclosure: I am long T. I may initiate a written call option on T within the next 72 hours.