Everyone thinks financial derivatives are weapons of mass destruction…  and to a large extent they are, especially if they fall into the wrong hands.  But if used with caution, derivatives and options can be handy little tools for incremental wealth creation.

Derivatives – Simpler Than They Sound

When most people hear the term derivatives, their minds freeze up because they think it’s complex math… and it is, but the simple truth is that you do not need to know any of that math to successfully use derivatives to help your investment portfolio… just as you do not need to understand the electro-mechanics of a car to be able to drive it, enjoy it and make full use of it.

Very simply, a derivative is derived from an underlying asset and builds upon it.  For example, options are simple derivatives based on shares.  A call or put option gives you the right to buy or sell shares at a predetermined price within a predetermined time frame…  that’s all, not very complicated, really.

So here are a few simple options’ strategies that investors must know and use to protect their portfolios on the downside, to lower the cost basis of their shares and to consistently generate incremental portfolio income.

Let’s start with a simple scenario.

Related: Short Strangle-Profit from Range Bound Stocks

Sell a Put (instead of buying shares outright)

Say you want to buy a few shares of Intel, the chip-making giant (INTC).

You could either buy Intel shares directly at $19.95 in the open market or sell put options with a strike price of $20 and an expiry date of December, and pick up 48¢ (the money you get when you sell the put option).  So now, should Intel shares close at $19.95 around the time that your options expire, you stand to gain 48¢ and your effective purchase price becomes $19.52 as opposed to $19.95.  If you’re in no rush to buy Intel shares and do not anticipate any significant price-changing event over the next couple of months, you could sell Intel put options with a strike price of $20 and an expiry date in February 2013 and pick up $1.05, and lower your entry price to $18.95.  Not bad!  So, as you just saw, put options can be used to lower the price at which you purchase shares.

Now let’s look at another use of put options.

Buy a Put (to lock in gains)

If the shares you own have risen significantly and you’re not sure if they might go up or down, and want to protect yourself should the shares fall… then you could buy a put option that gives you the right to sell the shares should they drop below the strike price within your option expiry timeframe.  Let’s look at this with another example.

Shares of a company called Flowserve Corp. (FLS) have risen from $40 in late 2008 to about $140 recently.  So Flowserve investors could buy put options that expire in July 2013 with a strike price of $140 for roughly $13 and effectively lock in a price of $127 should shares fall over the next six months. Here’s the simple math. You pay $13 to buy the put option, and when shares fall, you get $140 for your shares… so you effectively get $140 – $13 = $127.

And Sell a Call (to balance out the cost of the Put you just bought)

Now while it might pain a little to pay almost 10% as insurance protection, there is a solution.  Investors could also sell Flowserve call options with a strike price of $140 and the same July 2013 expiry date, and earn about $12 from selling the call.  In this case, the investor owns Flowserve shares and has established an options position at the net price of $1 only ($13 paid to buy the put – $12 received from selling the call).  Now if shares drop to say $120, our investor cashes out at $139.  Of course, should shares rise significantly, our investor would not benefit from this upside appreciation.

Related: Hedging Risk Exposure

Covered Calls

Another simple option strategy is to sell covered calls. Continuing with our Flowserve example, if the investor only sold Flowserve call options with $140 strike price and July 2013 expiry, he’d earn $12 but give up shares should they rise above 140, and still get an effective price of $152 ($140 for shares + $12 from selling the call).

If an investor holds shares in a company such as Intel or Microsoft with low volatility, he can continuously, over time, write covered calls to generate income provided he’s willing to give up upside potential.  So covered call strategies work well when the stock does not rise significantly above your strike price.

Don’t Fly Naked

One final note, while it’s tempting to write (sell) naked puts and calls, such actions expose investors to potentially devastating losses and are absolutely not recommended.

Dave Scott

Dave Scott

Dave holds an MBA in Finance and Accounting with over a decade of experience with US and international capital markets, investment research, asset management and writing on global financial and economic topics. Dave enjoys non-fictional reading, geopolitical news and events, and keeping abreast of finance, technology, and human follies and triumphs.