When most people think of options trading, they often imagine high-risk, short-term strategies designed for speculative purposes. However, there are conservative options strategies that can complement a buy-and-hold approach, helping investors generate additional income or manage downside risks. For long-term investors who prefer a “set it and forget it” mentality, options might seem complex or unnecessary, but in reality, certain strategies—like covered calls and protective puts—can be powerful tools for enhancing returns without taking on excessive risk.
In this article, we will break down the basics of options trading and introduce two key conservative strategies: covered calls and protective puts. These strategies can provide income, protect against market downturns, and help you achieve your long-term investment goals in a buy-and-hold portfolio.
What Are Options?
Options are financial derivatives that give the buyer the right—but not the obligation—to buy or sell an underlying asset (typically stocks) at a predetermined price (the “strike price”) within a specific time frame. There are two primary types of options:
- Call options: These give the buyer the right to buy the underlying stock at the strike price before the option expires.
- Put options: These give the buyer the right to sell the underlying stock at the strike price before the option expires.
Options are versatile financial instruments and can be used for various purposes—hedging, income generation, or speculative trading. However, in the context of a buy-and-hold strategy, the focus is on risk management and income enhancement.
Key Terms to Know:
- Strike Price: The price at which the option buyer can exercise the option to buy (call) or sell (put) the underlying stock.
- Expiration Date: The date on which the option expires and becomes worthless if not exercised.
- Premium: The price paid by the buyer of the option to the seller (writer) for the rights provided by the option.
With these basics in mind, let’s explore how options can be integrated into a conservative buy-and-hold strategy.
Covered Calls: Generating Income on Stocks You Already Own
A covered call is one of the most popular conservative options strategies for buy-and-hold investors. It involves selling (writing) a call option on a stock you already own, which gives someone else the right to purchase the stock from you at a specified price (the strike price) before the option’s expiration date.
How It Works:
- You own a stock: For example, you own 100 shares of a dividend-paying stock, say Procter & Gamble (PG).
- Sell a call option: You sell (or write) a call option on those 100 shares at a higher price than the current market price (the strike price). In return, you collect a premium from the buyer of the option.
- Three outcomes:
- If the stock price stays below the strike price, the option expires worthless, and you keep the premium as profit while retaining your stock.
- If the stock price rises above the strike price, the buyer may exercise the option, and you are obligated to sell your shares at the strike price. You still keep the premium, plus you get the strike price for your shares, locking in a gain.
- If the stock price drops, you keep the premium and still own the stock, but the stock’s value decreases.
Advantages of Covered Calls:
- Income Generation: Selling covered calls allows you to earn additional income on stocks you already own, even if they don’t appreciate in price. This is especially valuable in a flat or sideways market.
- Downside Cushion: The premium received from selling the call option provides a small buffer against any decline in the stock’s price. For example, if you receive $2 per share in premium and the stock drops by $2, you effectively break even.
- Modest Risk: Since you already own the stock, your risk is limited to losing potential upside beyond the strike price. You are not exposed to unlimited losses as with some speculative options strategies.
Example of a Covered Call:
Imagine you own 100 shares of Coca-Cola (KO), currently trading at $55 per share. You sell a call option with a strike price of $60, expiring in three months, and receive a premium of $2 per share. Here’s what could happen:
- If KO stays below $60: The option expires worthless, and you keep the $200 ($2 x 100 shares) premium as extra income.
- If KO rises above $60: The option buyer exercises the option, and you sell your shares at $60 per share. You miss out on any gains above $60 but keep the $200 premium, effectively selling your shares for $62 ($60 strike price + $2 premium).
- If KO falls: You keep the premium, which reduces your loss. For example, if KO falls to $52, you still keep the $200 premium, which offsets part of the $300 loss from the stock decline.
When to Use Covered Calls:
- Flat or Mildly Bullish Market: Covered calls work best when you expect the stock to trade in a range or have only moderate upside potential. If you believe the stock price will rise significantly, you might prefer to hold onto the shares without writing a call option.
- Income Enhancement: Investors looking for a way to generate income on top of dividends or capital appreciation can use covered calls to supplement their returns.
Protective Puts: Insuring Your Portfolio
A protective put is another conservative options strategy that can protect your investment from significant downside risk. It involves buying a put option on a stock you already own, giving you the right to sell the stock at a specified price (the strike price) if the stock’s value falls.
How It Works:
- You own a stock: Let’s say you own 100 shares of Johnson & Johnson (JNJ), currently trading at $150 per share.
- Buy a put option: You purchase a put option with a strike price of $145, paying a premium for the protection. This gives you the right to sell your shares at $145 if the stock falls below that level.
- Three outcomes:
- If the stock price rises, the put option expires worthless, but your shares have increased in value, offsetting the cost of the premium.
- If the stock price falls below the strike price, you have the right to sell your shares at $145, limiting your losses.
- If the stock price remains stable, the put option expires worthless, and you simply lose the premium paid for the option.
Advantages of Protective Puts:
- Downside Protection: A protective put acts like an insurance policy. If the stock price falls significantly, you can sell your shares at the strike price, limiting your losses.
- Unlimited Upside: Unlike other hedging strategies, buying a put option still allows you to benefit from any upside in the stock’s price. If the stock rises, the put option expires worthless, and you keep the gains on your shares.
- Peace of Mind: This strategy can help reduce the emotional stress of market downturns, especially if you’re heavily invested in a single stock or sector.
Example of a Protective Put:
You own 100 shares of AbbVie (ABBV), which is currently trading at $140. You buy a put option with a strike price of $135, expiring in two months, for a premium of $3 per share.
- If ABBV drops to $120: You can exercise the put option and sell your shares at $135, avoiding a larger loss.
- If ABBV rises to $150: The put option expires worthless, but your shares have appreciated, and the only cost is the $300 premium paid for the option.
- If ABBV stays near $140: The option expires, and you lose the premium, but you still own your shares.
When to Use Protective Puts:
- Market Volatility: Protective puts are particularly useful when market volatility is high, or you expect a potential downturn but don’t want to sell your long-term positions.
- Major Events: This strategy can be employed before earnings reports, political events, or other market-moving catalysts when you’re concerned about short-term risks but believe in the stock’s long-term potential.
Combining Covered Calls and Protective Puts: The Collar Strategy
For more conservative investors, the collar strategy combines covered calls and protective puts. In a collar, you sell a call option and use the premium received to help pay for the purchase of a protective put. This way, you limit both upside and downside potential, locking in a range for the stock’s performance while earning some income.
Example of a Collar:
You own 100 shares of JPMorgan Chase (JPM) at $145. You sell a covered call with a strike price of $155, collecting $3 per share in premium, and simultaneously buy a protective put with a strike price of $135, costing $3 per share. The call premium offsets the cost of the put, giving you a no-cost collar.
- If JPM rises above $155, you sell your shares at $155.
- If JPM falls below $135, you can sell your shares at $135, limiting your loss.
Using Options in a Buy-and-Hold Strategy
Options can be a powerful tool to enhance a buy-and-hold strategy when used conservatively. Covered calls provide additional income on stocks you already own, while protective puts offer downside protection during uncertain times. Both strategies allow you to continue holding your long-term investments while managing risk and generating extra income.
Understanding how to use these conservative options strategies can help you better manage your portfolio and potentially improve your returns over time. As always, it’s important to do your own research and ensure you fully understand any strategy before implementing it.
Happy Investing!