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Two Option Strategies for Retirees

Jason Stipp

Jason Stipp: I'm Jason Stipp from Morningstar.

It's Retirement Portfolio Week on Morningstar.com, and today we're talking about strategies outside the typical stock/bond allocations in a portfolio.

I'm joined today by Phil Guziec. He's a derivatives strategist and editor of Morningstar OptionInvestor newsletter. He's going to talk about two option strategies that retirees may want to consider.

Thanks for joining me, Phil.

Phil Guziec: Thanks for having me, Jason.

Stipp: So, a couple of strategies. The first one is an income-oriented strategy. It's something that could boost the income from your portfolio. This is an issue a lot of investors are looking for ways to get a little bit of extra income in today's environment. Can you explain a little bit about how that works?

Guziec: Well, the classic income-generation strategy using options is a covered call, which is actually the same transaction as the cash-secured put. In a covered call, basically, you sell the upside on a stock above the given price in exchange for a little extra income. So, you're kind of pulling ahead potential returns you might have in the future or giving up upside opportunity for cash today.

Stipp: So, can you explain in practice ... can you give me an example of how that might work and how that selling of the upside, what does that actually mean with an example?

Guziec: Well, let's say you have a company that you think the downside is relatively limited. You can also do this with stocks that you own that have already run up, and you're willing to give up upside above a certain price, but the best is if the downside is limited. And let's say that stock is trading for $20. You can buy the stock and then sell the call option at $21 or $20 or $22. The further out of the money, the higher the strike price you sell the option, the less income you get.

In exchange, you get some cash. If the price of the stock is above that strike price at expiration, someone will call the stock away from you. If not, you just get to keep the cash and you keep the stock.

Stipp: So not a bad deal in the meantime for you. Are there any disadvantages? What should be on investors' radars as potential downsides or risks to using the strategy?

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Guziec: Well, you're giving up your upside. So let's say that you have a huge market rally in these days that are notoriously famous, you lose a lot of your return if you miss out on these days with big upswings. Well, you're giving up that upside. If the market realities in that stock is up 50%, you're giving up all of that upside above the strike price.

Another concern is, you still have your capital exposed to downside. So, for example, if you owned Citigroup three years ago, and you said, well, I can just sell the call options on it and collect the dividend, you learn that the stock can crater, you can lose the dividends, and wind up with a tremendous loss.

Stipp: Any recent examples of companies where this strategy might have worked out for investors or any that have been on your radar as ones that they might want to consider employing this kind of strategy or just generally the types of stocks they might want to consider using the strategy on?

Guziec: Well, if you're an income-oriented investor, this works great for a dividend-paying stock, because if you buy the stock, you're collecting the dividend, you sell the call option. There is no free lunch. The dividend is priced into the call option, but you get some extra income from the call option. If the stock gets called away from you, so be it. If not, you get to continue collecting that dividend. So you have pretty secure income stream one way or another.

Recent great example that was a dividend-paying stock was St. Joe Corporation, a Florida real estate company that had been beaten down on short-term fears over oil washing up on the beach and nobody's developing real estate in Florida, and even though they own huge tracks of land right next to the coast.

The shares have gotten beaten down; the options have got very expensive, which is great when you're selling them, because the shares were beaten down, everybody was afraid of it, and in our portfolio we sold some put options on that, and they just expired worthless, and we made a very nice return.

Stipp: Very interesting case study there. The second strategy that you have involving options is one for the more risk-averse. Can you explain why it might be a good strategy for folks who are worried about the downside and how it works?

Guziec: Okay. Well, it's primarily a risk-aversion, risk-control thing. If you can't bear the thought of, say, a loss of more than 10% in any name in your portfolio or in your portfolio in general, you can put a collar on, which means you sell the upside above a certain strike and you take that premium that you receive and use it to buy protection below a certain strike decline. So, for example, if the stock was at $100, you would sell the $110 strike call and use that to buy a $90 strike put.

The classic and simplest one is what they call a costless collar, which is where you sell the call option and then you buy the put option that is fully paid for by the call option. And then you can tweak those strike prices around a little bit to maybe generate a little income, but then you are taking more downside risk.

Stipp: So you mentioned that with this strategy it's possible that you would be giving up some upside, but what other things should be on my radar as cons of the strategy? What should I have in mind before I would employ this in my portfolio?

Guziec: Well, again, you are giving up the upside and those big days, big swings, you are giving up that return. So over the long run, this may limit your portfolio's return. Also, puts tend to be very expensive to buy, and they usually are a little bit more expensive than the call options net-net because people are buying downside insurance. So out-of-the-money put options tend to be a little expensive, so that reduces you return, again, as well.

It's not a perfect strategy because, over time, on average, if you are giving up these upside big days and then things move sideways otherwise, you're giving up return, basically. When you remove risk, you also remove the return associated with that risk. And in this case, you're removing risk and the associated return.

Stipp: So, here where you're taking some of the premium from selling on the upside and then using it actually to buy the protection on the downside, it doesn't really sound like an income strategy. But when would you employ this? Is there a certain type of security that you might think about using this if you're worried about that kind of volatility that you might have on the downside?

Guziec: Primarily, it's a clientele thing. If you are very risk averse to the downside, if you can't tolerate a loss, it may make sense for you. I could see it making sense for dividend-paying stocks where it's a source of income and you can't bear having that principal reduced. It also makes a lot of sense for stocks that are likely to do reasonably well, however, have a small chance of a very large negative event--like a bank, let's say. So, it could make a lot of sense to collar your bank holdings, for example.

Stipp: All right. Phil, it sounds like two very interesting strategies for retirees to consider. Thanks so much for joining me today.

Guziec: Thanks for having me, Jason.

Stipp: For Morningstar I'm Jason Stipp. Thanks for watching.