Three popular strategies for trading stock options

Co-founder of the Switzer Report
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With the outlook for the US economy starting to look positive, I’m a little more optimistic than most about the direction for our share market. That said, it’s hard to see a big rally until the “Euromess” shows signs of being under control, and in these challenging times, exchange-traded options could have a role to play in your self-managed super fund – either to boost returns, or allow you to sit out and wait until confidence returns.

Before you consider trading options, you will need to do two things:

  1. Make sure that your SMSF’s written investment strategy allows you to trade options, and if not, modify it and then authorise via a Trustee Resolution. The investment strategy should briefly substantiate how the use of options will help enhance or protect your portfolio’s returns.
  2. If you haven’t got an options account with a broker, you will need to open one. Most advisory and online brokers such as CommSec offer these services, and as there is not quite as much competition here on brokerage rates, it may pay to shop around.

So, to the strategies. Let’s look at three popular ones (there are scores of them): the ‘long call and cash’, the ‘protected put plus stock’, and the ‘covered call’ or ‘buy and write’.

Long call and cash

With market volatility having fallen, this strategy is now less expensive. An at-the-money March 4,200 call (ASX code XJOLZ7) will cost around 112 points ($1,120), a June 4,200 (XJOW17) 210 points. If that is too expensive, the out-of-the-money 4,400 Mar call (XJOM47) is around 37 points, the 4,400 June call (XJOW97) 118 points. You will need around 2.38 option contracts per $100,000 of equity portfolio protection – and remember, the protection is time limited.

Protected put plus stock

Unlike the index options above, taking protection over a portfolio of stocks will involve multiple stock options. Volatility across most stocks has also fallen, so this strategy is now less expensive to implement.

Covered call (buy and write)

This is probably the most popular strategy for long-term share holders such as SMSFs because it can be used to enhance the income return on your portfolio and is particularly suitable to a range-bound market. Some insulation against a rising market can be achieved by selling out-of-the-money strikes – although this obviously reduces the income return.

If you are interested in the covered call strategy to boost income on your portfolio, be mindful that share options are ‘American style’, which means that they can be exercised at any time. Dividends can have a big impact – and if they are fully franked, they will be worth a lot more to an SMSF than they will be to the market.

For example, Commonwealth Bank (CBA) is due to go ex-dividend on 20 February and is expected to pay a fully franked dividend of $1.42. February CBA options expire on 23 February, so if your written call option is at or near the money as the ‘ex-date’ approaches, there is a strong chance that it will be exercised. While on paper this shouldn’t be a problem, it is unlikely that when CBA trades ex-dividend, the new CBA stock price will fully adjust for the grossed-up value of the imputation credits. One way to lessen this risk is to stick to option series well away from ex-dividend dates – for example, the March series rather than the February series.

The ASX has some great resources on options trading. If you want to learn more, the ‘Understanding Options’ booklet can be downloaded is a good place to start.

For more advanced option strategies, the ASX’s ‘Options Strategies’ booklet is also available.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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