Options for Hedging and Boosting Yield

In early February, I decided to protect some of our gains in ConEd (ED) by selling a third of our position, capturing a 29% gain and making it a little easier to sit through the ensuing correction. A subscriber who also reads my colleague Jacob Mintz’s Cabot Options Trader suggested that investors looking to do the same without reducing their position could write covered calls on the stock instead, which would generate additional income and make it a little “easier” to hold ED through volatile times. A handful of subscribers expressed interest in strategies like this when I shared his suggestion, so this month I’ll introduce some ways you can use options to hedge or create additional yield in your own portfolio (with credit to Jacob for the strategies). In addition to covered calls, which generate additional income on stocks you already own, I’ll also share hedging strategies using puts and spreads.

Covered Calls

Covered calls aren’t really hedges, but they can reduce risk in a way, and they’re a good way to generate additional income from positions you already own.

A call option has two parties: one investor who sells, or “writes” the call option, and one investor who buys it. The writer agrees to sell a stock at a specified price, the strike price, in the future. If he already owns the stock, it’s a covered call. (If he doesn’t, it’s a naked call, which is much riskier and which I won’t discuss here.) The other party in the transaction is the buyer. She is buying the right (although not the obligation) to purchase the stock at the strike price in the future.

Let’s look at an example, using a covered call on ConEd (ED). Because of external factors, I think ED is likely to stay at or below its current price of $64 per share for at least the next month. I don’t want to sell my position, but I would like to take advantage of this period of sideways movement to generate a little extra income. To do so, I can sell a call option on the stock, giving someone else the right to buy it at a certain price within the next 30 days. Since I’m hoping that doesn’t happen and I get to hang on to my shares, I’m going to choose to sell calls with a strike price of $70 that expire March 20. If ED trades at or above $70 before March 20, I might have to sell, but if it doesn’t, I’ll have made a little money.

The current bid price for a call option with those parameters is five cents. That’s the amount someone is willing to pay, per share, for the right to buy my ED shares at $70 anytime between now and March 20. When I sell the call option, I receive a premium of five cents per share, or $5 for 100 shares (options contracts are sold in 100-share lots).

As long as ED stays below $70 for the next 30 days, I get to keep the $5 and my ED position. It’s a small amount because this is a fairly conservative position: the odds that my shares will be called away are low. In addition, writing covered calls on dividend payers is a popular strategy, and they’re priced accordingly. You can generally make more by selling longer-dated calls or calls with a strike price closer to the current price. I could earn a premium of 15 cents per share for writing March 20 calls with a strike price of 67.50, for example.

I could also write longer-dated calls: right now, I could sell ED calls with a strike price of $70 that expire on May 15 for a premium of 25 cents per share. If I sell the calls and ED stays below $70, I’ll receive $25 per 100 shares, for a nice yield of 0.3% in three months. If I can do that four times a year, I can create an annual yield of 1.5%.

I could also sell long-term calls that expire in January 2016 or January 2017 for even larger premiums, although of course the risk of my stock being called away rises over longer time frames.

The other risk here is that ED continues to drop in price—a covered call won’t protect me from those losses (and it might make it more difficult to exit the position if it comes to that, since I’ll have to buy back the call first.) If you primarily want to protect against downside, you may want to consider one of these other options strategies.

Put Purchase

The most straightforward way of hedging against downside is by buying puts, which give you the right to sell the underlying security at the strike price. For example, Baxter (BAX) is a Dividend Growth tier position that has been seeing some downside pressure recently. It is currently trading at around $68.60. If I want to protect myself against a further drop in the value of my shares, I could buy puts that give me the right to sell at a price that I’m comfortable with. abot Dividend Investor 12 March 2015

Right now, I could buy March 20 puts with a strike price of $65 for 38 cents per share. I’d have to pay $38 for every 100 shares I want to insure this way, but if BAX drops below $65 in the next month, I can exercise my puts and sell my shares for $65 each. Just as with covered calls, the price depends on the risk you’re taking on: I could also buy puts with a strike price of $67.50, but they’d cost me 90 cents each.

You can also buy long-term protection this way: right now I could buy BAX puts with a strike price of $55 that expire in January 2016 for $1.35 per share. If the stock never falls that low, I’ll lose $135 for every 100 shares I chose to insure, but it might give me some long-term peace of mind.

Risk Reversal

This is a more sophisticated strategy, so you’ll need your broker’s permission to trade spreads to execute it. But it provides a truer hedge than selling calls and costs less than buying puts. However, unlike simply buying puts, it also caps your potential profit.

I’ll use the S&P SPDR (SPY) for this example since it has very high options volume. Let’s say you own 1,000 shares of SPY and want to hedge against downside risk by buying puts, but decide to cover some of the cost of the insurance by also selling calls against your position.

Right now, the SPY is trading at $211. To execute a risk reversal, you’ll sell calls with a strike price above $211 and buy puts with a strike price below $211 to hedge your position. This strategy reduces the capital that you have to pay for your hedge, but it limits your upside.

For example, you could sell March 20 calls with a strike price of $215 for 73 cents per call, and at the same time, buy puts expiring March 20 with a strike price of $210, for $2.54 per share. Your total capital outlay is $1.81 per share ($2.54 minus $0.73).

If the SPY falls below 210 in the next month, you can exercise your puts and sell your shares. However, if the SPY instead rises above $215, your shares would be called away from you by the holder of your covered calls. And if the SPY stays between $210 and $215, the position will expire worthless and you would be out the $1.81 per shares that you paid for the insurance.

Conclusion

Which of these strategies is right for you depends on the holdings in your portfolio, your risk tolerance and your desire for income. In addition, not all stocks are optionable: you might find it difficult or downright impossible to buy or sell options on some of the smaller names in our portfolio. But I think it’s clear that, far from being the instruments of wild speculation that many people perceive, options can be a useful tool for controlling risk and generating additional income from stocks you already own. If you’d like to see suggested options positions alongside some of our Cabot Dividend Investor holdings, let me know by emailing me at chloe@cabot.net.

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