Option Strategies to Enhance and Protect your Portfolio

In an environment characterized by low interest rates and an overheated stock market, finding income can be increasingly difficult. Investors are forced to seek other means of generating yield, and one effective and popular way is through the use of equity options.

There are several yield-enhancing strategies that can be implemented when using options, but a popular one involves monetizing volatility by selling option contracts against underlying stock positions. It’s particularly important in low-yield environments.

Longing and shorting stocks with equity options

This income enhancement strategy can be implemented with both long and short stock positions. Enhancing yield with equity options caps the underlying stock return, placing a maximum possible gain on your underlying position. Conversely, additional income that can be generated using option sales (Puts vs short stock and Calls vs long stock), indirectly provides protection on the downside by offsetting losses in the underlying stock.

With a long stock total return approach, investors focus on the complete return — which is the upside of the stock and the additional premium from selling the associated option contract. If a trader sells a $55 strike call against an underlying position, the trader will not participate in the stock return above $55, but will instead be compensated by the option premium. A total short stock return works in the same way, but in this case, investors are capping potential profit and loss by having a short put position on the downside versus a short stock position.

Premium vs potential upside

All investments come with trade-offs, and that’s also true with equity options. Determining which options are best used in these transactions becomes a balance of premium versus upside participation. Recall that capping your profit potential on your underlying position is balanced against the income you receive. The more you sacrifice your participation on the stock by selling options against it, the greater the premium income.

Longer duration options provide more income that short dated paper, mainly because you are carrying the risk of a longer term investment. You would be compensated more for taking a 6-month position vs only 1-month. A similar relationship exists with the strike price of the options you choose to sell. Options where the strike price is closer to current spot levels generate higher levels of premium due to the implicit cap on stock upside. An option position that caps upside on an underlying long position at $52.50 will provide more income than one that caps you at $55. The greater the potential profit participation you sacrifice, the higher the income from that option will be.

Income depends on underlying stock

The amount of income an investor can generate from an equity option strategy is only as good as the underlying stock they choose. There is a laundry list of criteria that goes into selecting a stock, but one of the main ones is typically the spread between the implied and realized volatility. Traders also look at the level of implied volatility versus the historical implied volatility, as well as the overall sentiment picture of the underlying stock. Other data points traders look to include earnings trends, fundamentals and momentum.

Hunt for enhanced income

Whether an investor chooses to go long or short a stock, or attempt to increase their return with equity options via longer or shorter term paper, what matters the overall risk/return profile. Even if the Federal Reserve raises rates this year, it is not expected to be a significant adjustment, which is why generating more income from investments should be a major focus for all types of investors.