The Motley Fool's Chief Financial Officer, Ollen Douglass, did a lot of things right when he bought call options on a handful of stocks in December 2008.
He used options that wouldn't expire until January 2011, so he had ample time to be proven correct. He diversified his investments across six companies, including Goldman Sachs (NYSE: GS ) , Red Hat (NYSE: RHT ) , Western Union (NYSE: WU ) , Cemex (NYSE: CX ) and Verizon (NYSE: VZ ) . Additionally, he knew the risks going into his trades, aware that if he was wrong about a recovery happening before 2011, he could lose much of his investment.
His swing largely worked out. Most of his stocks rebounded this year, and his call options in aggregate about tripled in value before pulling back. Ollen's not complaining, but he asked the Motley Fool Options team what he should do next and if he could have done better or invested with less risk.
After conversations with me and with our community, he sold his positions to lock in his profits -- because even today they were speculative and may not last -- and we pointed him toward several strategies that could have made his original trades more appealing.
Use option proceeds to buy options
The first thing Ollen could have done differently was to avoid putting his own capital at risk in making his call purchases. Given that he anticipated a rebound, he could have written (or "sold to open") put options near his targeted stocks' current prices, and then used the proceeds to buy call options, also near current share prices. This is called a synthetic long. It's a low-cost -- or no-cost -- way to mirror stock ownership. This also could have offered lower risk and lent itself to a longer holding period.
For example, last December 24, when Legg Mason (NYSE: LM ) traded at $20, Ollen bought $35 call options for $4.42 per share. This aggressive trade ultimately needed Legg to nearly double for the call options to end with a gain. Legg did rebound and was recently selling near $28, but that's still not nearly high enough to assure Ollen profits in the end. Instead, last December Ollen could have written (or sold to open) $20 put options and been paid several dollars per share; he then could have used the proceeds to buy $20 call options. Today, those calls would be worth at least double, while the puts would be profitable, too.
This synthetic long trade would have used "house money" and provided Ollen with a back-up strategy: If Legg didn't rebound by January 2011, he would be able to buy shares via the $20 puts that he wrote, and then continue to wait for a rebound. That's a much better alternative than simply seeing his original $35 calls end worthless.
Buy intrinsic value and sell time value
The golden rule of defensive option strategies is to buy intrinsic value and sell time value.
What do I mean? All options are priced in relation to an underlying stock and the option's strike price. When Goldman Sachs was $80 per share, only call options with a strike price of $80 or below had intrinsic value. Any call with a higher strike price was carrying only time value -- the price that speculators were willing to pay to bet that the stock would increase in price by expiration. As the expiration date draws nearer, though, time value steadily erodes and is worthless by the time the option expires unless the stock gains enough ground. You're buying a wasting asset.
Therefore, you want to write or sell options with time value, capture the premium yourself, and earn income on the likelihood that the stock won't move enough by the option's expiration. And you want to buy options with intrinsic value that won't waste away -- a $70 call, for example, when Goldman is trading at $80 -- so that even if the stock declines a bit, your calls will retain some value, and you can convert them to shares to get a second chance.
Although speculating in big rebounds has its place, Ollen could have lowered his risk by buying some calls with intrinsic value.
Diversify time risk
Over the last few years, Ollen placed a basket of option trades all at once at the end of each year. It worked in 2009, but some years this all-in strategy won't work nearly so well.
Instead, Ollen could have placed his trades over several months, moving into his various option strategies over time to benefit from volatility and avoid having all of his positions caught on the same wild ride from day one.
Last year, for example, his options -- all bought in December -- were looking downright ugly by the market's low in March. Luckily, Ollen has an iron stomach and rode it out.
Ready to use options foolishly?
Nobody can argue with Ollen's results. What's exciting to him -- and to Fools who use options -- is the fact that he could have done just as well, or even better, with less risk and more ways to profit in the end.
Ollen is aiming to do just that in 2010, using his real money to follow each Motley Fool Options recommendation the service makes in January. Using the Motley Fool's market-beating newsletter universe as our source, so far we've recommended options on everything from giant names like Microsoft (Nasdaq: MSFT ) to much smaller companies like Jack in the Box.
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