Options Aren't Just for Traders

04/04/2013 7:00 am EST

Focus: OPTIONS

There are several ways that investors can use options to maximize their portfolio returns, as well as to protect their holdings, says Bob Lang of Explosive Options.

Nancy Zambell: My guest today is Bob Lang, the founder and senior trading strategist for Explosive Options. We're on the investment side of things, so we're not going to do a lot of option trade setup, but Bob is going to help us out with some important option strategies for an investor's portfolio.

Bob, there are some ways for investors to use options that are not really risky or complicated. Can you tell us a little about those?`

Bob Lang: Nancy, there's a lot of mystery regarding options and how people can use them to gain the leverage that they provide to get a better return for their portfolios.

One of the better ways to use options as an investor is to be a net seller of options and take premium in. If I'm looking to buy a particular stock, and I believe that stock has gone up a little bit too high, and I would like to give myself enough time to be able to let that stock work down, I can just take in premium as a seller of a particular option, i.e., selling put options.

Now, obviously there's a lot of risk involved with options. But there's obviously risk involved with investing, anyway.

Selling put options is akin to just saying to yourself, "I would like to buy that stock at a lower price." The put option-by definition-gives you the obligation to have the stock put to you at a certain price.

For example, let's take IBM (IBM), and say you want to buy IBM at $200 or less. It recently closed at roughly $213...and you feel that that's a little bit overpriced-a bit more than you want to pay for it.

So you would look out a few months, thinking that IBM could fall if the market drops-maybe another 10%, down to $193 or $195. So you can sell some put options on the $200 strike, a few months out. That's out-of-the-money, so what you're taking in is called time premium or time decay.

You will be selling that option and getting a credit for time to kill. If you bought 200 shares of IBM today, it would cost you $4,200. But you said you would like to buy the stock at under $200.

So, if you sell that premium within a certain amount of time left and the market corrects, you can actually set yourself up to have that stock put to you at that particular strike. It's a great way to play the options market in a less riskier way than you normally would.

Nancy Zambell: Let's talk about using options for portfolio protection. We hear about that a lot, but I think most investors are not familiar with how to do it. Can you give us an example?

Bob Lang: I'm an advocate of always having protection on both sides of the market.

When the market was nose-diving back in 2008 and 2009, it was always smart to have some call plays on-just in case the market would pop-even though the market was trending down in a severe way. It works the opposite way when the markets are trending up-you want to always have some protection on.

In this particular case, today's market is rather low in terms of volatility. The volatility index recently closed under 13%, and what that tells you is that option values are cheap.

You can buy some very, very cheap protection against a long portfolio today by just buying some out-of-the-money Spyder Trust (SPY) puts. That's generally my preferred play, or the Russell 2000 ETF (IWM), or maybe even the Nasdaq ETF (QQQ).

Put option premium has been flattened out right now, because the market expectation is that there aren't going to be any really big sharp moves out into the next 30 to 60 days. Option premiums are low because the market expectations are that we're not going to have any wild movements.

Nancy Zambell: That makes a lot of sense, especially right now. The market has gone so high that people are getting a little bit wary about what's going to happen, so it probably is a great time to do a little portfolio protection thinking.

Bob Lang: Absolutely.

Nancy Zambell: Speaking of the market, Bob, I know that you are a market reader, so tell me what you're seeing ahead. Do you think that this rally is going to continue for a while, or are we going to go back into heavier volatility like we had a couple of years ago?

Bob Lang: For us to see that greater volatility, there has to be some sort of a catalyst, some sort of a reason for investors to be pulling the plug and saying "I'm going to get out of this market."

Two years ago-right around this time-there was a catalyst. Many people forget and don't realize how important that earthquake and tsunami was. It wasn't necessarily the damage that was done to Japan, but more likely the damage that was done to the psychology and mentality and emotions of investors.

It caused a lot of angst, a lot of volatility and uncertainty. Nobody knew what the aftermath of that tsunami was going to be for the rest of the world. They could have had a nuclear explosion that could have crippled the other half of the earth. Who knew? Nobody knew anything.

So when there's uncertainty out there, it's, "let me take my stuff off the table. I'll wait and see until everything is settled down a little bit, and then I'll put my chips back on the table." We had that uncertainty in August about the debt crisis, and market volatility went up. But eventually the can was kicked down the road a little bit.

There's a lot of uncertainty going on with Europe right now. Who knew what was going to happen with Cyprus? You need to see a catalyst to get volatility kicking back in.

The United States economy is not in necessarily horrible shape right now, and it may be actually be the best neighborhood or best house in a bad neighborhood, if you consider the whole world being a bad neighborhood.

To answer your question, I think there is some juice left in this market. There's a lot of money coming in; it's all liquidity-driven. The Fed is behind this market. Marty Zweig once said, "Don't fight the Fed." So that's where we're at now.

Related Articles:

Using Options as a Profit Center

Earn Income from ETF Puts

Insurance Against Market Correction

Related Articles on OPTIONS