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3 Good Reasons Why Stock Investors Should Learn About Options Today
At the time of writing this post, the All Ordinaries has rebounded about 30% from the March 2009 lows. Some individual stocks have even done better than that. Rio Tinto went up 80% from $43 in March 09 to $77 in June 09. The rally has taken a pause after touching 4000 and we really don’t know where the market will go from here. My personal view is that the worst is behind us but we are in a long slow recovery and the market will remain range bound like it was from 2000-2003 (see chart below).
As a stock investor with a knowledge of options, I believe now is a good time to think about using options to improve the returns of our stock portfolios in the next few years. There are at least 3 good reasons why I would use options:
1) To lock in my paper gains
If some of my stocks have made good gains since March 09, I could buy put options to lock in these paper gains. For example, Rio Tinto recently offered existing shareholders the rights to buy new stock at a deep discount to current market price. This caused the price to drop as shareholders sell shares to raise money to buy the new discounted shares. If I had bought 1 June 75 put option when RIO was trading at $77 per share, my put option would be worth at least $25,000 when it expired as the price of the stock was around $50, locking in the most of the paper gains I had when the stock was trading at $75 and above. The money I make from the put option can be used to pay for the rights to buy the new discounted shares. For long term buy and hold investors, buying puts to lock in gains is also preferable to selling the stock as you do not have to pay any capital gain tax.
2) To buy new stocks at a discount and get paid for waiting
If you are running your own SMSF which is in the contributory phase, you will always have new cash contributions which you need to invest. I am basically a value investor and prefer to wait until stocks reach a certain price before I buy. For example, if I think Telstra shares are a good value at $3.00 per share, I could sell put options at the appropriate strike prices to ensure I only buy at that price. I also get paid a premium for waiting to buy at that price.
3) Boost your returns by selling calls
Global trade volumes have fallen dramatically and this has affected earnings of most companies. When earnings fall, so do dividends and share prices. Even if you own defensive stocks like consumer staples or utilities, earnings are likely to remain stagnant and share prices will remain flat. My expectation is that the stock market will remain range bound in the next few years. This type of market conditions makes it hard to get good returns with just a buy and hold strategy where you get your returns from capital gains and dividends. However, these conditions are ideal for selling calls over your stock portfolio and this can help to boost your returns while waiting for the bull market to return.
I have posted more information about selling puts and calls in my earlier posts ( see posts on 1 June 2009 and 24 April 2009). If you would like to learn more about options, go to my Resource page which contains links to various options education resources.
Christina
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