Using options in a portfolio

HowTos: Beachman's approach to leveraging options to juice portfolio returns

May 10, 2023

One of my top goals this year is to learn about and try different types of options positions in my portfolio. To that end, since the beginning of the year, I have been experimenting with options and journaling about my experience. In this post, I will discuss what I have learned so far, what has worked, what has not worked as well as a few guardrails that I noted for my future options based actions.

Before we go any further, I have to put out this disclaimer:

I am not a skilled options trader. I have been mostly experimenting with them for the past 3-4 years and every trade is a learning experience. This post is not a comprehensive class on options trading. I am merely sharing my personal journey.

I am sure some of my readers are more sophisticated in their understanding and usage of options. Please share your ideas and feedback by hitting the Comment button below.

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Getting started

If you are wondering what are options, then a good place to start is here. If you decide that you want to delve deeper into this world, please be aware that it can get complex pretty quickly. On the other hand, investors who like strategy games, gaming theory and the study of markets might find it to be an interesting new area of investor sophistication and potential profits.

I bought the book “Options as a Strategic Investment: A Comprehensive Analysis of Listed Option Strategies” by Lawrence G. McMillan. I have also been watching many YouTube videos, perusing my broker’s options educational material and reading anything options-related that comes to my inbox and Twitter feed.

There is definitely a lot of educational material about options out there. Most of it caters to advanced options strategies and tries to draw you into subscribing to their service and becoming an active day trader. I recommend first spending more time learning and less time doing. Then tip-toe into the waters with some small sized trades. Don't get discouraged by initial failures and don’t let early wins get to your head. This stuff is complicated and takes years to master. And if you jump in right away with a lot of money, the wrong decision can hurt your portfolio in a hurry.

Goals and rules

Most people use options for short term / long term trades or to generate income using their current portfolio. My goals are different.

I use options to:

Improve my chances of buying a stock that I want to add to my portfolio at my preferred price.
Gain income while waiting to trim a current holding at a price where I expect it to get overvalued.

Did you see the bolded text above? I use options as a means to serve my core equity portfolio. Nothing more and nothing less…at this time. Usually, I gain income doing so when I sell options to fulfill one of the goals above.

Over time, I have documented a few rules that I want to adhere to:

I don’t want to take unnecessary risk with options on my varsity stocks. I do not want to lose them if I make the wrong move because these are high conviction stocks that I want to own for a longer term.
I prefer to use weekly options (weeklies) especially in today’s cautious market. Since I am using options for the stated goals above, I prefer to take shorter term options positions where I can better align with the stock’s price action and the market’s sentiment.
Some stocks only offer monthly options (monthlies). So that is what I use if necessary.
I prefer selling options (to earn premium) rather than buying them at a cost.
I shy away from options positions that need a lot of active and daily monitoring.
I do not use 0DTE options.
I do not use margin for my options.
I try not to sell options positions during earnings season for fear of a major up or down move in the stock after the earnings report is out.

Covered CALLs

I sell covered CALL options when I want to trim a stock (that I already own) at a particular price because I would consider it overvalued at that level.

Before I place the trade, I:

Identify my preferred strike price for the CALL. This is usually equal to or just above my preferred trim point.
Pinpoint the expiration date for the CALL. Sooner the better…see my comment about weeklies and monthlies above.
Review historical and current prices for those CALL options. If they have dropped significantly on that day, I hold off and check back in the next day. I prefer to sell options on days when the options price has risen.
I want to, at a minimum, earn an annualized 30% premium on the options position.

NOTE: When you sell a covered CALL option, the shares that you own and have staked for this trade are put on hold. You cannot sell them before the option expires.

Example

Let’s use a hypothetical to better understand my approach. NOTE: These numbers are not real nor are based on actual financial analysis.

Assuming that I own 200 shares of SHOP.
They are currently trading at $57 / share.
I think that the stock would be overvalued if they rise to $65 and I want to trim 100 shares if they touch that level.
Looking at prices for the May 12th (weekly) $65 Call options, if I sell a covered call, I can earn a premium of $0.29 * 100 shares = $29 per options contract. Each options contract always contains 100 shares.
The total capital at stake for this trade is 100 shares * $65 = $6,500.
These 100 shares of SHOP that you own are “frozen” until the option expires. You cannot sell them. You can still earn dividends if issued by the company.
The $29 weekly premium represents a 23% annualized return. This is calculated as $29 * 52 weeks = $1,508 / $6,500 = 23.2%.
This is below my required 30% premium rule, so I might have to pick a lower strike price to earn more premium or walk away from the trade and try another day.
If I pick the $63 strike price, my premium would be $49/100 shares which comes to a 39% annualized return. But then I am taking on more risk by choosing a lower strike price.
If on May 12th the stock closes higher than $63, the option would get assigned, my 100 shares will be sold at only $63 and I could lose $1.51 profit on each share by selling too early.
The $1.51 profit loss is calculated as preferred trim price - options strike price - options premium earned i.e. $65 - $63 - $0.49 = $1.51.
The question I have to decide is whether the $0.49 premium is better to earn now at the risk of maybe losing $1.51 of gains in stock price.

Secured PUTs

I sell secured PUT options when I want to buy a stock at a particular price because I would consider it undervalued at that level.

Before I place the trade, I:

Identify my preferred strike price for the PUT. This is usually equal to or just below my preferred buy point.
Pinpoint the expiration date for the PUT. Sooner the better…see my comment about weeklies and monthlies above.
Review historical and current prices for those PUT options. If they have dropped significantly on that day, I hold off and check back in the next day. I prefer to sell options on days when the options price has risen.
I want to, at a minimum, earn an annualized 30% premium on the options position.

NOTE: When you sell a secured PUT option, the cash that you staked for this trade is put on hold. You cannot use this cash for anything else before the option expires.

Example

Let’s again use a hypothetical to better understand my approach. NOTE: The numbers are not real nor are based on actual financial analysis.

Assuming that I want to own 100 shares of SHOP.
They are currently trading at $57 / share.
I think that the stock is overvalued right now and I want to buy that stock at no more than $50.
Looking at prices for the May 12th (weekly) $50 Put options, if I sell a secured put, I can earn a premium of $0.24 * 100 shares = $24 per options contract. Each options contract always contains 100 shares.
The total capital at stake for this trade is 100 shares * $50 = $5,000.
$5,000 from your account’s cash balance is “frozen” until the option expires. You cannot use that cash for anything else. You cannot withdraw the cash from the account either.
The $24 weekly premium represents a 25% annualized return. This is calculated as $24 * 52 weeks = $1,248 / $5,000 = 24.96%.
This is below my required 30% premium rule, so I might have to pick a higher strike price to earn more premium or walk away from the trade and try another day.
If I pick the $52 strike price, my premium would be $43/100 shares which comes to a 45% annualized return.
If I take this trade and if the stock closes lower than $52 on May 12th, I will be forced to buy at $52 per share.
My actual price per share is calculated as options strike price - premium earned i.e. $52 - 0.43 = $51.57 per share. This is higher than my preferred $50 price target.
So I have to decide if the $0.43 premium per share is better to earn now at the risk of paying $1.57/share above my preferred buy point.

Conclusion

As you can see from the two examples above, options trades can offer an investor more flexibility as they are making adjustments in their portfolio i.e. buy shares or trimming existing positions. However, they come with more variables, more decisions, more complexity.

With an options trade, you have to be “right” with the direction (call or put), the strike price for the option and the time (expiration date).

It is not easy. And through trial and error, an investor has to find the right approach that works for her portfolio.

I will continue testing other options strategies such as hedging with options and generating recurring income with options.

Stay tuned.