Safeguard Your Investments With These Proven Techniques – Modest Money

Are you ready to dip your toes into the world of options without the typical risk? Engaging in low risk option strategies might sound like an oxymoron given the inherent risks associated with options trading. Remarkably, despite estimates of 75% of options positions resulting in losses, the right strategies can harness the power of leverage and hedging to tilt the odds in your favor.

For those daring enough to navigate the complex currents of options trading, this guide illuminates a path through safer waters. If you found your way to this article, I’m assuming you already know option trading basics. These strategies I will be getting into might be slightly difficult to understand if you don’t know the very basic information about option trading.

I’ll be getting into some of the preferred low-risk options strategies like: covered call writing, protective put buying, and collars. These techniques are your arsenal for crafting a cautious yet potentially rewarding approach to options trading. Stick with me as we explore each strategy to determine how best to integrate them into your winning strategy.

Key Takeaways

• Put-Call Parity ensures fairness in options pricing by aligning the values of European puts and calls with the same strike price and expiration.
• Arbitrage Opportunities are rare but can provide risk-free profits by exploiting discrepancies between call and put prices.
• Dividend Effects can significantly alter option prices, particularly impacting put-call parity calculations and option values on ex-dividend dates.

Low Risk Option Strategy #1: Covered Call Writing

Covered call writing is a cornerstone strategy for traders looking to enhance their portfolio’s income through options. This approach involves holding a long position in an asset while simultaneously selling call options on the same asset. It’s particularly favored by investors seeking to generate additional income from their stock holdings, especially in flat or mildly bullish markets.

Name of Strategy: Covered Call Writing

Bullish or Bearish:Neutral to Bullish

When to use this strategy: This strategy is best employed when you expect the stock to rise modestly or remain stable. It’s ideal for generating income in a flat market where significant price movement is not anticipated.

Advantages of this strategy:

• Generates income on existing stock holdings through the premiums received from selling the call options.
• Provides a limited hedge against modest declines in the stock’s price.
• Allows investors to set a potential selling price for their stock, which can be strategically chosen based on target returns.

Risks of this strategy:

• Limited upside potential, as the gains on the stock are capped by the strike price of the sold call. If the stock surges above the strike price, the additional gains are forgone.
• The stock can still lose value, although the premium received provides some cushion. However, significant drops in the stock price can lead to losses that surpass the income from premiums.

Examples:
Suppose you own 100 shares of Company XYZ, currently trading at $50 per share. Expecting the stock to not move much in the near term, you decide to write a covered call by selling one call option with a strike price of $55 and an expiration in one month, for which you receive a premium of $200.

• If XYZ stays below $55, the option expires worthless, and you keep the $200 premium, boosting your earnings from the shares.
• If XYZ rises above $55, the option may be exercised, and you will have to sell your shares at $55. While you miss out on any additional gains above $55, you still benefit from the stock appreciation up to $55 and keep the $200 premium.
• If XYZ’s price falls, for example to $45, you still keep the $200 premium, but your stock loses $500 in market value (from $5000 to $4500), resulting in a net loss of $300 despite the premium. This scenario highlights the risk where the decline in stock value can offset the benefits from the option’s premium.

Low Risk Option Strategy #2: Protective Put Buying

Protective put buying is akin to purchasing insurance for your stock portfolio. This strategy involves buying put options for stocks you already own, providing a safety net against potential declines in stock value. It’s particularly useful for investors who want to protect their gains or minimize potential losses without selling their actual stock holdings.

Name of Strategy: Protective Put Buying

Bullish or Bearish: Bullish (on the underlying stock), Bearish (on the put option as protection). It is a hedge to safeguard against Bearish market movements.

When to use this strategy:
This strategy is best used when you are optimistic about the stock’s long-term growth but concerned about potential short-term declines. It’s ideal ahead of uncertain events that might lead to stock volatility, such as earnings reports or economic announcements.

Advantages of this strategy:

• Provides a safety net that limits potential losses without requiring the sale of the stock.
• Allows investors to remain exposed to potential stock gains while being protected against significant losses.
• Can be tailored to specific risk tolerance levels by choosing puts with different strike prices and expiration dates.

Risks of this strategy:

• Cost of purchasing puts can reduce overall investment returns, especially if the puts expire worthless.
• If the stock price increases, the cost of the put option represents a missed opportunity to increase net gains since the premium paid for protection reduces overall profitability.

Examples:
Imagine you own 100 shares of Company ABC, currently trading at $100 per share. Concerned about potential volatility, you decide to buy a put option with a strike price of $95, expiring in three months, for which you pay a premium of $5 per share ($500 total).

• If ABC’s stock price falls to $85 at expiration, your put option allows you to sell the stock at $95 despite the market price. Your loss on the stock is $5 per share ($10 drop minus $5 premium), rather than $15 per share, effectively reducing your potential loss.
• If ABC’s stock price remains above $95, the put expires worthless. You lose the $500 spent on the premium but maintain all the benefits of any stock price appreciation above the initial $100 price.
• In a scenario where the stock falls dramatically, say to $75, the protective put limits your effective sale price to $95. Here, the put option significantly mitigates your loss, offsetting the decline by allowing you to exit at $95 instead of $75, effectively saving $20 per share, minus the $5 premium, for a net saving of $15 per share against a potential $25 per share loss without protection.

Low Risk Option Strategy #3: Collars Options Strategy

The collar option strategy is a risk management technique used to protect gains and limit potential losses in a stock position. This strategy involves holding the underlying stock while simultaneously buying a protective put option and selling a call option. The collar is an effective way to hedge against significant price fluctuations without foregoing all potential upside.

Name of Strategy: Collar Option Strategy

Bullish or Bearish: Neutral to Bullish (optimistic about the stock but want downside protection)

When to use this strategy: Use this strategy when you want to protect unrealized gains in a stock without selling it. It’s particularly valuable during periods of increased market uncertainty or when a significant rise in the stock’s price makes it susceptible to a correction.

Advantages of this strategy:

• Provides downside protection by limiting potential losses through the put option.
• Reduces the cost of buying a put through premium income from the sold call option.
• Allows investors to maintain their position in the stock and participate in potential upside up to the call strike price.

Risks of this strategy:

• Caps the upside potential due to the call option—any stock price increases beyond the call strike price will not benefit the holder.
• Still incurs a cost if the premiums of the put and call options don’t offset each other.
• The investor must be willing to sell the stock at the call’s strike price, potentially missing out on further gains.

Examples:
Suppose you own 100 shares of Company XYZ, which are currently trading at $50. To protect your investment and still allow for some potential upside, you decide to implement a collar strategy. You buy a put option with a strike price of $45 and sell a call option with a strike price of $55, both expiring in three months. The put option costs you $2 per share ($200 total), and you receive $2 per share ($200 total) from selling the call option, thus offsetting your costs.

• If XYZ’s stock price drops to $40, the put option allows you to sell your shares at $45, limiting your loss to $5 per share compared to a potential $10 loss without the put. The cost of the strategy is offset by the call option premium received, so your net protection cost is zero.
• If XYZ’s stock rises to $60, your shares are called away at $55. Although you benefit from the price increase from $50 to $55, you do not participate in any gains above $55. Your profit is capped at the call strike price, but your initial downside protection was cost-free.
• If XYZ’s stock price stays between $45 and $55, both options expire worthless. You keep your stock and the net cost of the strategy is zero because the premiums paid and received offset each other.

Low Risk Option Strategies: My Final Thoughts

By using some of the low risk option strategies covered in this article, you can better protect your portfolio from whatever the future of the market has in store. Although these strategies can be used to produce significant results, it will come down to how and when you end up using these strategies.

To find potential winning option plays and keep up on option related news, it takes continuous learning. I suggest subscribing to an options trading newsletter, like Motley Fool Options, in order to maximize your wins.