In any discussion of an investment strategy, we begin with a series of assumptions. Our assumptions tie in to your conservative profile: You have prequalified stock; you believe these stocks will rise in value over time; fundamentals are essential in stock selection; you would be happy to buy more shares; and there are a number of companies that meet your standards. We have identified 10 companies that make up a "model portfolio" to illustrate the options strategies in this book.
This book explains how conservative investors can employ option strategies to (a) enhance current income without increasing market risks; (b) protect long-positions through options used for insurance; and (c) use options as a form of contingency in volatile market conditions.
The Ground Rules
Because you are a conservative investor, we base all of the arguments in the book on a series of underlying assumptions. These ground rules should always be kept in mind because they relate to your risk profile and to your investing philosophy. We use five underlying assumptions in this book:
You will limit option activities to stocks you have prequalified. We assume as a necessary starting point that your portfolio—and the stocks you use for options strategies—includes stocks you believe in as long-term-hold stocks and that you consider these stocks permanent parts of your portfolio (as long as the fundamentals remain strong). This is an important attribute because it is not conservative to buy stocks solely to use for options strategies. A conservative approach to options must include the premise that your activities will be limited to the strongest possible stocks you can find.
You believe that your stocks will rise in value. A conservative investor naturally expects stocks to rise in value; otherwise, why keep them? But this seemingly obvious point has relevance in the underlying assumptions of this book. Many of the discussions of strategies are premised on a belief that over the long term, the subject stock’s market value will rise. Many options strategies work best when stocks do not rise, so our second underlying assumption is in line with the conservative approach. This means you want to accumulate shares of value investments; you expect prices to rise over time; and you will change a hold to a sell when the fundamentals change. However, at the same time, some options strategies are designed to take advantage of short-term volatility. When marketwide volatility affects short-term prices in your stocks, you have an opportunity to pick up discounted shares, take profits (without having to sell stock), or average down your overall basis. Of course, the proposal that you should average down would be conservative only if the basic assumptions were valid. You would want to employ such a strategy only for stocks in which you have a strong belief as long-term value investments.
You accept the premise that fundamental analysis of stocks is an essential first step in the process of examining option opportunities. There are no fundamental attributes for options. These are intangible contractual instruments, and they have no value on their own; thus, you can only judge the tangible value of stock as a means for selecting appropriate options strategies. Many first-time options traders make the mistake of overlooking this basic reality. They select options (and stocks) based on the immediate return potential, but ignore the very real market risks of the underlying stocks. This violates the conservative tenet that stocks should be chosen for their fundamental strength and growth potential.
In the event of a temporary downward movement in a stock’s price, you would be happy to buy more shares. Some investors may be unwilling to pick up more shares of a particular stock, even when the opportunity to buy discounted shares is presented. In this book, several strategies are introduced proposing that additional shares may be purchased (or exposed to contingent purchase) using options. If this is not the case in a particular situation, then those suggestions should be passed over. You may have a strict formula for diversification or asset allocation that you use to limit risks in any particular stocks, for example, so strategies aimed at increasing your holdings in one stock would contradict your portfolio management standards in such an instance. Strategies proposing that you set up situations in which more shares may be picked up work only if that suggestion conforms to your overall portfolio plan.
You believe that there are an adequate number of available stocks that meet your criteria. Some investors become convinced that their short list of stocks is the only list available to them. Thus, if they were to sell shares of stock from their portfolio, they would be unable to reinvest profits in equally acceptable stocks. We assume that you do not believe this and that you are aware that probably dozens of stocks meet your fundamental criteria—in terms of price level, PE ratio, volatility level, dividend payment history, and a range of other analytical tests. Accordingly, if a particular stock is sold from your portfolio, we also assume that you are tracking a number of other stocks that you could and would purchase upon sale of stocks you currently own.
Incidentally, this practice makes sense whether you trade options or not. The fundamentals can change for any stock, so if a hold stock changes to a sell, you need to reinvest funds. As a matter of basic portfolio management, every investor probably has a secondary list of stocks that would be used to replace sold stocks from the current portfolio. The need for maintaining this list relates to options trading because some strategies result in selling shares of stock. In those cases, you want to reinvest capital in a new issue on your list of qualified stocks.