3 Strategies for Less Risk and More Profit

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.

Want to take your investing to the next level in 2010 and invest alongside The Motley Fool's CFO in Motley Fool Options? Enter your email in the box below to receive your invitation!

Foolish analyst Jeff Fischer owns none of the companies mentioned in this article. Western Union and Cemex are Motley Fool Stock Advisor recommendations. Western Union, Microsoft, and Jack in the Box are Inside Value choices. Motley Fool Options has recommended puts on Western Union, covered calls on Jack in the Box, and diagonal calls on Microsoft. The Motley Fool owns shares of Legg Mason. The Motley Fool's disclosure policy likes intrinsic value.


Read/Post Comments (8) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 09, 2009, at 11:16 PM, TMFEdyboom223 wrote:

    hi

  • Report this Comment On December 10, 2009, at 7:46 AM, maxanova wrote:

    what about Einstein's theory' seems m m simple )-:

  • Report this Comment On December 10, 2009, at 9:43 AM, memoandstitch wrote:

    Using proceeds from writing put options to buy call options is essentially doubling your bet. In your example, if LM dropped to $10, he would have lost money from both the call option and the put option. It looks more risky that just buying a call.

  • Report this Comment On December 10, 2009, at 11:03 AM, mikecart1 wrote:

    Zzzz...zzzz....zzzz....

  • Report this Comment On December 10, 2009, at 11:08 AM, RobertC314 wrote:

    I have to agree with Memo in that this first suggestion basically doubles down.

    MF tends to do this where they gloss over what happens on option expiration. In the situation above, if the stock goes down he would have been on the hook to buy ALL the shares under contract. There are generally 2 possibilities when buying options:

    1. Buy/sell options as an investment. This leverages your holdings and, in order to make the investment significant, you must buy a relatively large number of contracts (for example, if you want to invest $1000 in options you may have to buy 10 contracts. That gives control over 1000 shares. If you wanted to invest $1000 in that same stock you may only be able to buy 100 shares). This method generally increases risk.

    2. Buy/sell options as an intermediary step in buying/selling the underlying stock. In this case you want to be able to cover the underlying security. In this case you must buy options on the basis of the strike price and the underlying stock. Going back to the numbers above, we would only buy/sell 1 contract (not 10) and only have $100 "invested" in the options. This method generally decreases risk.

    From a practical standpoint, you cannot mix these types of investments. If you invest using method 2 then, even if the option value skyrockets 200%, you have only made $200. If you had simply invested the $1000 to begin with you would probably have made 20% on that investment and made the same $200. The real advantage comes if the stock drops severely in value, say it drops in half. Your option becomes worthless and you lose $100. If you had simply bought the stock you would have lost $500.

    You can argue about the value of having that $900 free for the duration of the option, but I am fairly certain that for most MF investors the trading friction on the options will more than cover the difference. In addition, if you use the method suggested in the article then you will have to either have sufficient funds or sufficient margin on your trading account to cover the puts anyway, so that money cannot be used for anything else.

    Generally speaking, buying options has less risk than dealing directly with the underlying security because it limits your downside (for a cost). Similarly, selling options increases your risk compared to dealing with the underlying security, but you get paid for the increased risk. This "risk" is in absolute dollar terms though, and when options are used to leverage positions the relationship is less clear. All other options strategies use combinations of these to increase or decrease risk in certain scenarios based on what you "think" is going to happen.

    The other suggestions in the article are sound though. The third applies to buying stocks as well as options, however, you have to be careful that trading costs don't get the best of you in this case.

  • Report this Comment On December 10, 2009, at 11:10 AM, dtarends wrote:

    Instead of a synthetic long, why not just buy the stock? You would have just one commission from buying the stock instead of three commissions (writing the put, buying the call, and exercising the option). While options have a place in investing, to portray options as a panacea is misleading. One can always forecast a scenario where options work wonderfully, but they can be the worst thing to do as well. Motley Fool seems to have drifted over the years from providing investing information to selling products. Many of the articles are merely ads in disguise.

  • Report this Comment On December 10, 2009, at 11:10 AM, RobertC314 wrote:

    I have to agree with Memo in that this first suggestion basically doubles down.

    MF tends to do this where they gloss over what happens on option expiration. In the situation above, if the stock goes down he would have been on the hook to buy ALL the shares under contract. There are generally 2 possibilities when buying options:

    1. Buy/sell options as an investment. This leverages your holdings and, in order to make the investment significant, you must buy a relatively large number of contracts (for example, if you want to invest $1000 in options you may have to buy 10 contracts. That gives control over 1000 shares. If you wanted to invest $1000 in that same stock you may only be able to buy 100 shares). This method generally increases risk.

    2. Buy/sell options as an intermediary step in buying/selling the underlying stock. In this case you want to be able to cover the underlying security. In this case you must buy options on the basis of the strike price and the underlying stock. Going back to the numbers above, we would only buy/sell 1 contract (not 10) and only have $100 "invested" in the options. This method generally decreases risk.

    From a practical standpoint, you cannot mix these types of investments. If you invest using method 2 then, even if the option value skyrockets 200%, you have only made $200. If you had simply invested the $1000 to begin with you would probably have made 20% on that investment and made the same $200. The real advantage comes if the stock drops severely in value, say it drops in half. Your option becomes worthless and you lose $100. If you had simply bought the stock you would have lost $500.

    You can argue about the value of having that $900 free for the duration of the option, but I am fairly certain that for most MF investors the trading friction on the options will more than cover the difference. In addition, if you use the method suggested in the article then you will have to either have sufficient funds or sufficient margin on your trading account to cover the puts anyway, so that money cannot be used for anything else.

    Generally speaking, buying options has less risk than dealing directly with the underlying security because it limits your downside (for a cost). Similarly, selling options increases your risk compared to dealing with the underlying security, but you get paid for the increased risk. This "risk" is in absolute dollar terms though, and when options are used to leverage positions the relationship is less clear (but still holds true). All other options strategies use a combination of these to increase or decrease risk in certain scenarios based on what you "think" is going to happen.

    The other suggestions in the article are sound though. The third applies to buying stocks as well as options, however, you have to be careful that trading costs don't get the best of you in this case.

  • Report this Comment On December 10, 2009, at 11:11 AM, RobertC314 wrote:

    Damn... double post - MF needs to do something about that

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