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Options Trading: Is Diversification Necessary?

Posted June 21, 2012

Topics: Finance & Investing

Traditional wisdom tells us that diversification is a foundation of wise portfolio management. Is this still true? Or are there ways around it? Can you put all your eggs in one basket without any risk of loss?

Diversification is not necessary if you can skillfully devise no-cost or low-cost strategies to eliminate all market risk.

The collar is a good example. By opening OTM short calls and lnog puts at the same time, one contract of each per 100 shares of long stock, you eliminate all downside risk below the put's strike. If price falls below that level, any losses are offset by selling the put at a profit or by exercise the put and selling shares at the strike.

On the upside, if stock moves above the call's strike, shares are called away.

So where is the benefit?

If you place your funds into high dividend yielding stocks and focus on dividend income -- and not on option or stock gains -- you can create a risk-free net return. For example, many companies yield above 4% dividend per year. If you could eliminate risk of losses on the stock, would you be happy with annual return of 4%

Example: Altria (MO) closed on June 19 at $33.92 per share. You could create a collar with August 34 calls (0.69) and August 33 puts (0.42), netting 0.27 before trading costs. Or if you want a longer period of protection, the January, 2013 35 calls were at 0.89 and the 30 puts at 0.82, a net credit before transaction costs of 0.07. Why Altria? Because it yields 4.84% dividend per year, almost a 5% return and even more if you reinvest dividends in additional shares, the annual compound return is 4.93%.

Most investors would be very pleased with this return. And remember, the market risk is eliminated and the collar is close to zero cost.