Investing in Today's Environment
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DEFENSIVE MOVES AN INVESTOR CAN TAKE:
Two Strategies for Today's Volatile and Unpredictable Market
1. Sell Covered Calls
Also called covered option writing, this involves selling a call option against stock you own. Selling a call option generates income to you the investor from the sale of the option. You give the buyer of your the call option you sold the right to buy your stock at a prearranged contract price known as the strike price for a term which can run up to two years. What you the investor are betting is that the price of your stock will not exceed the strike price within the time frame of the contract. An option held by the purchaser usually gives him the right to purchase 100 shares of stock at a prearranged price.
Say you own the XYZ company that you purchased at $20.00 a share. You do not expect this stock to appreciate much say within the next six months and is selling today for $24.00 A call option expiring in six months at a strike price of $25.00 may sell for $3.50 per option (premium), $350.00 for the 100 shares. The option price is determined by market volatility and the time before its expiration date among other factors also. If you were to sell an option, write a call against the stock you own, you would receive $350.00 less commission. In six months if the stock does not go above $25.00 a share, the option expires and you still have your stock, the option premium plus any dividends earned. If the shares go above $25.00, you can expect your stock to be called away (sold) at $25.00 per share to the buyer of the option. Note: most stock is not called away from the investor until the week of option expiration unless the stock price dramatically increases before.
Should the stock price dramatically decrease before the option's expiration, the decline may be more than the premium you received plus dividends. However, you mitigate your loss to some extent.
2. Use A Collar
A collar involves selling a call option as discussed above and using the proceeds to buy a put option, which gives the investor the right to sell the same shares at a prearranged price. A collar locks in a narrow price range for your stock during the option's term for little or no cost.
Using the example of the XYZ company above of writing a covered call and receiving $350.00 less commission, an investor would then buy a put option with an expiration date the same as the call date for say a $20.00 strike price and pay say $275.00 plus commission. What you have done is guaranteed your stock will stay between the price of $20.00-$25.00 and possibly pocket a small return from the difference received and paid on the two options plus any dividends. If the stock falls to $15.00 per share at expiration date, you pocket the difference discussed above and exercise your option to sell (put the stock to the seller of the put) at $20.00 per share. What you have effectively done here is put a floor beneath your potential loss. Of course your gains from this strategy are smaller than selling covered calls.