Options: They're Not As Complicated As You Think

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Includes: O, T, TGT, XOM
by: SA Marketplace
Summary

Believe it or not, options can be a solid strategy for managing risk and generating income.

Ryan Linski of Parsimony Investment Research joins the Roundtable to talk about his approach to options investing, and how it's not as complicated as people think.

Having been humbled by the markets in the past, Ryan believes making an investment plan and sticking to it is the best strategy for success.

Ask any stalwart dividend investor how they feel about a market downturn, and they'll typically tell you day-to-day market movements don't keep them up at night, as long as those dividends keep rolling in. Still, with most market pundits predicting some kind of pullback or correction in the markets sometime this year, even dividend investors with the heartiest of constitutions are likely looking for strategies to manage volatility and risk in their portfolios. One often misunderstood strategy to accomplish this is to invest in options like cash-secured puts and covered calls. It sounds complicated - and lots of investors shy away from options because they have a reputation for being complex, risky and finicky. But done right, they can potentially serve investors of all stripes well - including income investors - and provide some upside protection in times of market turbulence.

That's precisely what Ryan Linski of Parsimony Investment Research sets out to do for investors who enroll in his self-study course, the Triple Income Formula. Ryan is the first to offer an educational course (rather than an ongoing subscription service) on Seeking Alpha's Marketplace, and we think it's worth checking out. The course is designed to help educate investors from novice to experienced on how to leverage conservative options strategies and dividend stocks to generate more income. Ryan joined us to talk about the philosophy behind the Triple Income Formula, the importance of sticking to an investment plan, and how dividend investors can use options to enhance their existing income strategies.

Seeking Alpha: What is the Triple Income Formula, and can you discuss how you developed this approach?

Ryan Linski of Parsimony Investment Research, author of The Triple Income Formula: The Triple Income Formula combines the income-generating power of conservative option strategies (like cash-secured puts and covered calls) with the structure and stability of a long-term dividend stock portfolio. In other words, it gives investors the ability to enhance the income generated from a stock-only dividend portfolio (often by 3-4x). In fact, the Triple Income Formula targets 1% income per month (which is very achievable).

This approach was developed to meet the two main needs/wants of our clients/subscribers:

  1. Prudently maximize portfolio income

  2. Preserve capital and minimize downside volatility

The Triple Income Formula accomplishes both.

SA: Obviously, dividend investors evaluate key criteria like yield, buy and hold, to DRIP or not to DRIP, etc. What else do you consider when investing in dividend stocks, and how does your approach differ, perhaps, from other dividend investors?

PIR: First and foremost, our approach starts with a proper investment plan. It’s nothing fancy, but I think one of the biggest mistakes that investors make is investing without a plan (especially those just starting out).

These are our four simple principles to building and managing a successful dividend portfolio (in order of importance):

  1. Asset Allocation/Position Sizing (i.e., how much should you buy of each dividend stock?)

  2. Exit Strategy/Risk Management (i.e., when should you exit a stock or hedge your dividend portfolio?)

  3. Stock Selection (i.e., which dividend stocks should you choose for your portfolio?)

  4. Entry Strategy (i.e., when should you buy a specific dividend stock?)

Other than that, I think our approach differs from most in that we make investment decisions more from a portfolio perspective vs. an individual stock perspective (i.e., we try not to get "married" to our stocks).

We closely monitor the income that our portfolio is producing as a whole and we are constantly trying to balance our two goals of maximizing portfolio income and minimizing portfolio volatility. Sometimes that means taking profit on (or rebalancing) winners and reallocating that capital into opportunities that are trading at more reasonable valuations. I think this is hard for many investors (especially “buy and hold” investors) to do.

SA: How can adding options help enhance investors' existing strategies? Is your particular approach applicable only for dividend investors?

PIR: I like the way you phrased that question because our option strategies are truly a perfect way for dividend investors to “enhance” their portfolio income and manage their risk. That said, these strategies could be used by any type of investor who is seeking more income (but most dividend investors usually fall into that camp).

Both cash-secured puts and covered calls are income-producing option strategies (because you are “selling” the options and collecting the premium income from the sale). In addition, both strategies have unique ways to complement a dividend portfolio.

For example, cash-secured puts are a great way to patiently wait for the appropriate low-risk entry points on high-quality dividend stocks that you want to own at a lower price (i.e., the put acts as a downside “limit order” on the stock, which also builds in a margin of safety). And the best part is, by selling the put… you get paid to be patient. Cash-secured puts are also a great method of acquiring stock.

Covered calls on the other hand allow you to generate additional income on stocks that you already own (without using additional capital). Covered calls are a great way to opportunistically take profits on stocks you are considering selling (i.e., the call acts as an upside “limit order” on the stock).

SA: For most investors, portfolio volatility - especially the avoidance of it - is important. You characterize options as a risk management tool. Many investors who are unfamiliar with options view them as increasing risk rather than decreasing it, so your approach is interesting. What are the benefits of investing in options, and how do you use them to manage risk?

PIR: In our opinion, risk management is all about minimizing portfolio volatility. As discussed in the previous question, these option strategies force you to be patient and stick to your plan!

Cash-secured puts allow you to generate a nice income yield (which is often well in excess of the actual dividend yield on the underlying stock) and they give you a built-in margin of safety before negative price fluctuations in the stock affect your capital base.

Similarly, Covered Calls allow you to generate income and selectively take profits (which we view as a key risk management strategy). Portfolio risk is reduced every time you can reallocate capital into more reasonably priced assets (and get paid to do it).

SA: Related, but slightly different, let's talk about risk tolerance. You say you tend to invest in more "conservative" options strategies. For those who aren't as well-versed in options, what does a "conservative" options strategy look like, and how does your approach differ from, say, a more "aggressive" options strategy?

PIR: By “conservative”, we mean that we use option strategies that do not use leverage.

Options get a bad rap because most investors get too aggressive with them (usually with poor position sizing). Just because options offer an investor leverage… it doesn’t mean you have to use it!

By “cash-securing” our put positions, we are setting aside all the cash to buy the stock if it drops below our strike price. This forces us to stick to our position sizing rules.

In addition, some investors get into trouble using “complex” option strategies (which we define as any option strategy that uses more than one option). Examples of complex strategies include straddles, strangles, spreads, iron condors, butterflies, etc.

While there is nothing inherently wrong with trading complex strategies, most investors don’t fully understand the risk/reward dynamics involved in these complex trades and don’t understand all the moving parts.

Our main strategies (cash-secured puts and covered calls) only require one option to execute (as you know, we like to keep it simple!).

SA: How do you strike a balance between traditional dividend investing and options in the portfolios you manage?

PIR: The balance comes naturally because we utilize these option strategies to “complement” our dividend stock portfolio. Our core dividend strategy is based on buying high-quality dividend stocks at good prices… and that is what drives our decision making. We then utilize the option strategies to help achieve our goals of maximizing income and minimizing portfolio volatility.

For example, we only write cash-secured puts on dividend stocks that we would like to own in our portfolio at a lower price.

All that said, we do limit our long dividend stock positions to 60% of our total capital so that we have cash available to take advantage of good cash-secured put opportunities (which tends to be the largest source of income).

SA: What are some factors in the current market environment that make options an attractive bet for investors now?

PIR: This is actually the perfect environment to use these option strategies as the markets continue to make new highs. It seems that most market participants believe a pullback or “breather” is likely on the horizon for the major equity markets.

In our opinion, this is a prudent time to consider selectively taking some profits on stocks that have rallied significantly (using covered calls).

In addition, this is certainly not the environment where you want to chase stocks higher with new purchases. Cash-secured puts give you the ability to generate income with a built-in margin of safety.

SA: You mention you've been humbled by markets in the past. What was a particularly humbling moment for you, and what lessons did you learn from it?

PIR: I think anyone gets humbled by the market when they lose money…and I have had my fair share of losses. In fact, I never consistently made money in the market until I got serious about creating an investment plan (and sticking to it). It’s no secret that most investors fail because they don’t have a proper plan.

The Triple Income Formula is a great example of a simple plan that works consistently if you follow it.

It’s so easy to get sidetracked as an investor with all the information available to us these days. Chasing “hot stock tips” and jumping from strategy to strategy will eventually catch up to you (in a bad way).

The best advice I can give any investor stems from the biggest lesson I have learned over the years… the path to long-term investing success is all about creating an investment plan and sticking to it!

SA: What's your single best investment idea for the latter half of 2017, and why?

PIR: This may sound lame, but I don’t have a “single best investment idea” (other than creating a proper investment plan, of course).

The Triple Income Formula is built to consistently hit singles and doubles (so I’m never really focused on finding the next home run). I just try to put the odds of success in my favor by focusing only on high-quality stocks at reasonable valuations.

Don’t get me wrong, the strategy produces its fair share of success stories. However, the “home runs” rarely come from the stocks you are most confident in (isn’t it funny how that works).

All that said, I do think there will be a rotation back into some of the weaker performing sectors year-to-date (like Telecom, Energy, Retail, and REITs) as investors shift their focus back to value.

Some high-quality dividend stocks that I think are trading at reasonable valuations in those sectors include: AT&T (NYSE:T), Exxon Mobil (NYSE:XOM), Target (NYSE:TGT), and Realty Income (NYSE:O).

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Thanks again to Ryan for joining us. You can follow his work here and check out his service, the Triple Income Formula, here.

Please follow the SA Marketplace account at the top of the page to stay on top of everything new in the Marketplace. We publish the Roundtable every Saturday. We'll be hosting a special Energy Week Roundtable starting Monday, so be sure to check the SA Marketplace author page daily for fresh investing ideas from some of our top Energy authors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Parsimony Investment Research is long all stocks mentioned.