Can options work in a conservative way and actually help protect your portfolio?

Most conservative investors traditionally have seen options as high-risk, speculative plays on short-term market swings. This is understandable when you think of the many high-risk option strategies available. But increasingly, options are going mainstream as even the most risk-averse investors are finding ways to use option contracts to lower risks and protect their long stock positions.

Three basic ways this is accomplished:

  1. Covered call writing. The covered call has two parts: Ownership of 100 shares of stock, offset by the sale of a call. When you sell, you grant someone else the right (but not the obligation) to buy your 100 shares at a fixed strike price, on or before a specific expiration date. You keep the cash you get for selling the call and all dividends you earn before exercise. If exercise doesn't happen, you still own your shares and after expiration of the short call, you can repeat the strategy. Two important qualifications: You must be willing to give up your 100 shares at the strike price (which should be higher than your basis in the stock), and you must also be willing to give up any appreciation above the strike if and when the stock's price takes off.
  1. Long puts for insurance. Let's say you bought stock you want to keep for the long haul and its value has soared very high and very quickly. You expect some degree of reversal because prices went up so fast. So you're tempted to sell and take profits while you have them; but you still want to hold onto the stock for the long term. The alternative is to buy one put for each 100 shares. If the stock price declines below the put's strike, the put's intrinsic value will rise for each point you lose in the stock. This caps your downside risk for the period the put is alive, and the premium you pay for the put is the cost of protection, the insurance you gain with this strategy.

  1. Long LEAPS calls for contingent purchase. A LEAPS is a long-term option. The acronym stands for Long-term equity anticipation securities, a fancy name for options that may exist as far out as 30 months. So if you like a company's stock today but you can't afford to buy 100 shares, investing in a LEAPS call is one choice. This creates a "contingent purchase" position. You control 100 shares but your risk is limited to the cost of the LEAPS call. You can exercise it any time you want before expiration. So months later when you have the cash but the stock's price has risen well above the strike, exercising the call fixes your price no matter how high it has moved since then, so you can buy 100 shares for much less money than it would have cost buying at current market value.

There are many additional ways options can be used to conservatively protect portfolio positions and also to increase cash profits. The point is, options are not only for the high-risk strategy and they no longer are used only by speculators. Investors can also make options work in conservative strategies.