Options: Less About Sizzle, More About What’s at Stake
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Last week I took a deeper dive at how we plan to use dividends to drive returns in a paper trading portfolio called the “No Drip, No Mess” Portfolio. Today, I want to wade in to the topic of how we’re using options to strategically build a portfolio. Too many investors have been burned by how they’ve used options; we’ll review how to use them sensibly.
Maybe it’s because I’m writing this as I sit by the pool with a very relaxing atmosphere making it the perfect place to review a couple of the options trades I’ve recommended for the portfolio. If you’re like me, when you first started trading options you were buying out of the money calls in hopes of earning windfall profits from some catalyst on the horizon. If that describes your start, this probably describes your end -- the catalyst never materialized or the market didn’t react as you thought it would. This caused the option’s value to go up in flames faster than that Fourth of July BBQ that you took your eye off of, giving a pleasant onyx hue to its flavorful charcoal crust.
Options don’t have to be about the sizzle of quick returns. Like dividends, slow and steady can make for many happy returns. You won’t find me making much mention about how our options positions are performing because we’ll most often use them as a sort of limit order to build our stake in a company I want to own for the long term.
As we begin our second month into this venture and I’ve recommend 13 trades that have the potential to invest up to 44% of the portfolio’s $100,000 in virtual cash. Yet, we’ve still only invested just 11% of that cash balance as a majority of the portfolio remains allocated for potential put obligations. Through these option strategies, we’ve generated 1.83% of cash for the “No Mess” side of the portfolio, leaving us needing just a little bit more income before adding a new sizzling position to the portfolio. As we lounge around and wait for options expiration day on most of our trades, let’s review why we are taking such a leisurely approach to these positions.
I’ve devoted a lot of time and energy to begin to build up the energy allocation of the portfolio. I’ve recommended writing puts on Linn Energy (NASDAQ: LINE), Rex Energy (NASDAQ: REXX) and Enterprise Products Partners (NYSE: EPD), which if all three positions are assigned we’ll have invested nearly 10% of the portfolio in energy investments. We did so with two goals in mind: collecting the put premium and hopefully picking up our stakes a little lower than if we bought them outright. If our options were to expire today, we’d only have earned the put premiums. When you write an option, you are really only interested in what happens at expiration. These options will move wildly in the interim, flaring up as the stock drops and fizzling out as the stock remains above the strike price as expiration nears.
Most of our option positions don’t expire until the latter half of the year. Our closest expiration is in mid-August when our puts on Seaspan (NYSE: SSW) are set to come into port. As it stands right now these puts would expire for full income as the shares are currently 15% higher than our strike price. Hopefully we’ll see shares begin to drift lower so that we can write new puts soon after expiration.
As the fall draws near we have two more puts to keep an eye on, the aforementioned Rex Energy and our newest addition, PetMed Express (NASDAQ: PETS). Both companies have market capitalizations of under a billion dollars making them a bit more volatile. In both cases you’ll see their option prices move wildly but as we near expiration we’ll either pick up our desired shares or we won’t. All that sizzle won’t mean much to us because we’re really just interested in picking up our stake in each company. If we don’t end up with our stake, that sizzle should provide us with a higher option premium if we need to write puts again.
Did you notice an ongoing theme? By writing options we’re only really concerned with the end result. While we can look ahead and anticipate our next move, there isn’t much we need to do in the meantime. We’re simply using these options as a tool to stock ownership. Over time we’ll generate a lot of income by writing options given the fact that about 80% of options expire worthless. Until expiration, we just need to sit back and relax, not concerned by the sizzle of the option pricing, it’s the stake at the end of the sizzle that matters.
latimerburned owns shares of Linn Energy, LLC, Enterprise Products Partners L.P., and has a covered call on Seaspan. The Motley Fool owns shares of Seaspan. Motley Fool newsletter services recommend Enterprise Products Partners L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.