Options: How Much Risk Is Right for You?

Your risk tolerance determines the size of an acceptable premium

   

Using options to generate income can be a great strategy, but like everything in the stock market, risk is always involved. And that risk isn’t always quantifiable in terms of how much upside or downside you are potentially giving up for the return you get in the form of a premium.

For example, if you sell a covered call against your position and the stock shoots well beyond your strike price, you’ve given up that profit while protecting yourself against the downside. Was it worth it? Only you can decide.

If you’re playing this game for income, then you must be ready to lose a position you hold, or possibly get stuck with one you didn’t expect.

Here are some examples across the risk spectrum that will help illustrate what I’m talking about and perhaps offer guidance as to what strategy you may want to pursue.

Low Risk: Let’s say you do not presently hold General Electric (GE) but have been thinking about it. One of my favorite solutions not only generates income, but also might give me a position in GE at less than its present price. As of this writing, GE trades at $24.33. The July 24 Naked Put sells for 48 cents. So if I sell those puts, I’m making about 2% of the stock’s value on the trade going out four-and-a-half weeks, for a 24% annualized return. That’s a nice, safe play because I will collect that premium regardless, and because I believe GE is going to be a solid stock over the long term, I’m not sweating if it gets put to me at $24 (or $23.52, effectively).

Medium Risk: Let’s take a stock that has rebounded well off its lows, but for which there still exists a degree of skepticism: Green Mountain Coffee Roasters (GMCR). The stock trades at $79.30 right now, but for the life of me, I have no idea whether the company will be around in five years or if it’ll be the next ten-bagger. There’s more risk here, so if you hold the stock but are thinking of getting out, you could sell the July 80 Call for $3.30, which is a 4.1% absolute return, and 49% annualized. The risk is two-fold — the stock could crater (which it would anyway, but you wouldn’t have sold the call to offset some of that fall), or it could take off. You might be bummed at losing out on that upside, but still have captured some nice income.

High Risk: Well, what’s higher-risk at this point than Netflix (NFLX)? There are plenty of bulls out there that pushed the stock from $60 to $228.83. I happen to be bearish and think the company will eventually implode, but I’m not willing to bet my money on it. Let’s say you don’t hold the stock, but darn it, you wish you had captured some of that delicious upside. Well, things might be stable in the stock for the next month, so you could sell the July 230 Naked Put for $12.86. That’s about a 5.65% absolute return or 68% annualized. That kind of return may make that trade worthwhile to you. Of course, if the company stumbles, you can probably bet it’s going to fall more than 12 bucks in one day.

As of this writing, Lawrence Meyers was long GE. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at pdlcapital66@gmail.com and follow his tweets @ichabodscranium.


Article printed from InvestorPlace Media, http://investorplace.com/2013/06/options-how-much-risk-is-right-for-you/.

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