Beginners Guide to How to Build A Diversified Portfolio and use Covered Call Options

Financial Freedom will not simply happen by accident!!  You Must Have a Plan.

What on earth are people going on about when they talk about their investment portfolio? In this blog I will demystify this for you and explain why you should never keep all your eggs in one basket. I will also throw some light on a very secret way that clever banks ‘insure’ their investments by using a thing called the Options Market.

Creating a Diversified Stock Portfolio

The beginners guide to creating your own diversified investment portfolio

By the end of this blog you’ll fully understand how to build up a selection of shares that are spread across lots of sectors like pharmaceuticals, property, construction, technology and banking so that even if we have another one of those unpleasant ‘banking crisis’ or another ‘property problem’ your investments will survive.

The central concept in portfolio allocation is to decide on a rule for spreading your investments over various industries.

Tim Lowe Ultimate Beginners Shares Investing Guide

I strongly recommend, as does Warren Buffett, you do not put all the proverbial eggs into one basket. Alternatively do no rely on just one little piggy. I urge investors to generate income from multiple sources and shares. This blog is dedicated to how you invest your allocation to the stock market investment class.

Diversifying your stock holdings serves to reduce risk by avoiding exposure to one particular company’s stock price. You never know when a specific company might release news which sends its share price spiking up or down. If all your investment lies in that one stock then your account value is extremely sensitive to the movement in just one company. It rarely pays to back one horse.

Apologies for all the clichés but it is critical for successful investment that you devise a suitable allocation plan and then adhere to it! It is all too easy to break your own rules. I have done it too. The important point is to monitor your account regularly to ensure you are aware of any over allocations within your account.

What I mean by over allocations is that over time as your investments grow you might see a surge in one companies stock price more than your other stock. so imagine you have 3 stocks in ‘pigs’ ‘chickens’ and ‘foxes’ and you buy £1000 of stock in each. You have a good equal spread across three animal sectors. Now lets say that Chickens do really well and increase to £2000 but the other 2 stocks stay the same price.

Too much chicken is bad for you

Whats happened is you have gone from having an even 33% of your portfolio in each animal to having half of your entire portfolio now in chickens simply by your own success. This would be the time to sell of some chicken and buy a new animal stock to keep a good balance.

Diversify your investments via Sector or Industry

Diversification should not only focus simply on owning several different companies. You should aim to diversify your stock investments across multiple industries or sectors. There is no point owning 10 different shares in the one industry in an attempt to diversify. Should that one industry suffer a downturn specific to it then your diversification will have little benefit to you.

So now as well as having chickens, foxes and pigs you might want to add some wheat or even some solar panels to your ‘investment farm’ . That way no matter what happens you’ve got some money rolling in and food on your plate.


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Hence I recommend you select different companies from several different industries.

The ten crucial sectors all investors should be spread across

The Dow Jones refers to 10 broad sectors as follows:

  1. Technology
  2. Financials
  3. Telecommunications
  4. Health Care
  5. Consumer Goods
  6. Consumer Services
  7. Oil & Gas
  8. Basic Materials
  9. Utilities
  10. Industrials

Value Line categorises stocks in the market into almost 100 different industries. They are all listed on the Value Line website. For example, see below how Value Line breaks down the Technology Sector into multiple industries:

Sector: Technology

Technology Industries:

Software & Computer ServicesComputer Hardware
Computer Services

Electronic Office Equipment
Internet


Semiconductors
Software


Telecommunications Equipment
Technology Hardware & Equipment

Do your Homework to be a successful investor

In my fantastic blog about Fundamental analysis I showed you how to do your research.  We want to own stocks with sustainable dividends and growth. You are equipped to identify top quality stocks at good value. On our website you will find many companies for which we have already prepared the quality and value assessment. These are updated quarterly which should save you lots of time in your research.

Researching for dividend yielding stocks

You want a nicely balanced portfolio where no single position can cause significant downside to your investment value. Think back to keeping roughly the same number of chickens, foxes and pigs on your ‘investment farm’

How to build a balanced stock portfolio

How do you achieve balance in your portfolio?

Portfolio Size has an impact on your level of diversification (but insurance is required in all portfolios!) primarily because generally we must purchase 100 shares of a stock so that we can collect income from options.

Here are some guidelines for various portfolio sizes.

  • $100,000 – 10 stocks from different sectors ideally or use ETF’s
  • $30,000 – 5 or 6 stocks from different sectors or use ETF’s
  • $10,000 or lower – harder to diversify here. Maybe 2 or 3 or use ETF’s.

Designing or Building Your Share Portfolio

My Stock Selection Model Evaluation

You will recall from my other blogs on fundamental analysis we aim to own stocks which score top marks of A rating on both Quality (Q) and Value for Money (V). We do often consider B rated stocks also. The lower the rating scores the higher the level of insurance cover you should consider. Ideally stocks with an “A” rating for Quality and an “A” rating for Value for money will fill your portfolio. Stocks lower than B ratings really ought to be considered speculative stocks and I advise no more than 10% of your portfolio should be held in such stocks.

Dollar Cost Averaging in Investing

It is always a sensible idea to Dollar Cost Average into your stocks. Why? If you wish to buy say 1000 shares of Company X then to buy all at once leaves you no opportunity to buy some if the share price should come on sale at a discount for some reason.

I suggest you work your way into shares in three steps buying each additional tranche only at lower prices. This allows you to reduce your average cost price and sets you up for higher investment returns than otherwise.

There is no shortage of top quality companies to choose from so do not worry if the stock goes up and you miss a chance to establish your full desired position. Patience is a key ingredient in successful investing in any arena. Stocks are no different. I tend to hold some unallocated cash in our account at all times to allow us take advantage of sudden price drops in top quality names which only happen occasionally for various reasons.

For example, the announcement of a terrorist attack may send certain stock prices lower although there may be very little fundamental impact on the company performance in reality. I’ve seen stock of decent aircraft manufacturers like Boeing drop off the back of an airliner crash, nothing has changed in the company but the market has become fearful so I see these price drops as opportunity.

Timeliness Rank (Value Line)

Please refer to the blog on the Value Line Investment ranking system for Timeliness. I recommend you select companies with a minimum rank of 3, but ideally rank 1 or 2

Outperformance of Timely Stocks

See below an excerpt from Value Line which clearly illustrates how selecting only Timeliness Rank 1 stocks for your portfolio has yielded long term outperformance over versus the market average. This is a strong case for stock pickers v ETFs.

How Valueline Timeliness stocks outperform all others in the long term

Diversified Investing Strategies

I recommend you employ a variety of strategies to invest in your chosen stocks. There is obviously greater scope to use a wider variety of plays in a larger account. However, you can still use this technique in smaller accounts too.

For example, say you can only afford 1,000 shares. Assume you have dollar cost averaged into them. You should have decided what you were going to do with them BEFORE you bought them i.e. Plan your Trade, Trade your Plan but always remember to have a Plan B.

I cover the concept of ‘renting out your shares’ on a separate blog here

You could have decided to collect short term rent say 1-2 months out on one tranche. You may have decided to collect income or rent from long term calls say 1 year out on the next tranche. On the third tranche you may decide to collect intermediate term rent say 6 months out.

As you progress your education with these blogs I will teach you about more sophisticated strategies which allow you to collect rent or income from shares which you do not even own. That is for another day though. You must master the basics before ever attempting advanced strategies.

How to Buy Shares at a 20% Discount

My blogs show you how to design plays in your accounts which will help you to build a portfolio at 15-20% discounts from current prices. Imagine the head start this would give you over the people who simply buy at the retail price! I cover this more in my blog about Technical Analyis.

BUY at WHOLESALE Prices!

how to buy shares at a discount

Value Line Model Portfolios

In Value Line’s research website you will find they present four suggested Model Portfolios per below.

  • Model Portfolios I, II, III, IV – Value Line has 4 main portfolio suggestions

Personal risk appetite & income objectives will impact your selection if you wish to use these as a guideline off the shelf so to speak.

Model Portfolio I –  Above average potential for price appreciation

Timeliness

In this portfolio stocks should have a Timeliness rank 1 & 2 only. Please note these stocks are more volatile which means there is more risk to share price spikes up or down in the short term. Value line suggest considering selling the stock if their timeliness rank falls to #3 or lower.

Drawbacks of this kind of investment portfolio

The concern with this portfolio design approach is it tends to include higher risk stock selections and it can be hard to get diversified as qualifying stocks may be clustered in a small number of industries.

Advantages of this kind of investment portfolio

NB. We cannot forget that Timeliness Rank #1 – outperform S&P 14 to 1 (cumulatively) over past 40 years to 2010 ..or 12% pa for Rank 1 v 6% pa S&P (this is based on owning all the Timeliness rank 1 stocks (of which there are 100 at any given time). See earlier chart above.

Model Portfolio II – Income & Potential Price Appreciation

This portfolio design is somewhat more conservative than Model Portfolio I above. This portfolio tries to combine timeliness ranks with income objectives.

Dividend Yield

To qualify for selection to this portfolio a stock must have a dividend yield above the median figure of all Value Line stocks.

Timeliness

The minimum Timeliness rank allowed is #3 (so it must have a rank of 1, 2 or 3).

Advantages of this portfolio

Typically this portfolio will be less volatile as companies which qualify tend be more mature, predictable and the dividend yield supports price in difficult market conditions.

Drawbacks of this portfolio

You are unlikely to see the price appreciation potential of the Model I portfolio. However, as in all walks of life only you can decide what suits you.

Model Portfolio III – Long Term Price Growth Potential

The focus on this portfolio is 3-5 years price growth potential (see Value Line one pager, top left corner)

The risk level for this type of portfolio falls between Portfolios I & II. It tends to be the most diversified as stocks from many industries will likely qualify.

Model Portfolio IV – Above Average Dividend Yield

The focus here is on current income yield in terms of dividends.

Dividend Yield

  • To qualify for selection for this portfolio the stock must have a dividend yield at least 1% above the median of all dividend paying stocks covered by Value Line.

Timeliness

  • Also, the Timeliness rank must at least be 3.

Financial Strength of Investment Portfolio

  • The value line score for Financial Strength must be at least B+. This rating is found at the bottom right hand corner on your one page value line report.

CAPITAL PROTECTION – The Ten Essential Rules to Protect Your Investment Portfolio

Your selection of top quality stocks and good value for money entry points will always serve to protect your portfolio to a large extent. However, there are specific capital protection techniques which can be employed because even top quality stocks can fall in price sometimes.

There are several specific methods each investor can utilise to protect their capital. Each method offers different levels of protection. Each has different costs to consider. It will be a personal choice as to which you use depending on your risk tolerance and income yields desired. Capital protection is often referred to in layman terms as insurance. Just like when you buy a house or a car you would typically buy insurance to protect the asset value.

You can insure your stocks against going down just like you can insure your car or house

Whilst a share price is not going to burn down it may fall in price. Unlike property we can actually buy insurance policies to effectively limit the loss we incur should the share price fall.

The higher the level of protection you seek the higher will be the cost. If you select top quality companies at high value for money levels then the level of protection required is arguably lower than 100%. Such companies are highly unlikely to go out of business in the near future. Hence, why would you want to protect their price from falling to zero? If you thought this could happen your shouldn’t be buying a stock like this in the first place

This is a personal choice of course. During the financial crisis of 2008 to 2009 many high quality companies saw their share prices fall significantly albeit nowhere near to zero!

You will recall my references to the rollercoaster ride of the market. Share prices go up and down. Employing insurance techniques will certainly reduce and limit any losses which may occur. It will help you sleep well at night as you will not need to worry about the stock market general movements or even specific share price movements.

Protection (Insurance) Techniques

  1. CASH
  2. Portfolio Allocation
  3. COVERED CALLS
  4. PUTS – Short term
  5. PUT SPREADS
  6. PUTS – LEAPS
  7. Married Put Spreads
  8. Married Puts
  9. Market and Stock Entry – Timing
  10. Dollar Cost Averaging & Position Sizing

Investment Capital Protection Techniques

If some or all of these ideas are new to you don’t worry . Ill go through them one by one here.

Cash

  • Holding your capital in cash will certainly ensure you avoid any capital devaluation as a result of the stock market or specific shares falling in value
  • Holding cash will not protect you from the devaluation impact of inflation. Inflation trends around 2-3% per annum. If you own good quality dividend stocks you will find they often increase their dividends by more than 3% p.a. Hence the real value of your dividend income can actual rise.
  • Cash deposits yield typically less than 2% p.a. Sometimes higher rates are available for long term deposits with restrictions on access to the cash etc.
  • I prefer to hold some cash at times when we feel the market has possibly rallied too high too fast. Holding cash in these circumstances is a deliberate tactic which aims to take advantage of price falls to allow us to reinvest at lower prices. This requires patience to wait for the stocks we want to come ‘on sale’ so to speak!

Investment Portfolio Design & Allocation

  • I discussed this in detail at the beginning of the blog. It is important you do not overexpose your portfolio to any one share. It does not matter how good you think the company is, if it suffers a fall your entire portfolio will drop.
  • The impact on your account will depend on how much of the protection plays which follow below you have actually employed.
  • Hold several high quality timely stocks, from several industries, which have passed my evaluation model rating analysis.
  • Average your way into positions rather than piling all in at once. Nobody has a crystal ball which accurately predicts future share prices. If you come across someone who tells you they do then be very wary!
  • Even the best full time professional investors make timing errors. So averaging in is a tactic to be employed by all investors.
  • Be patient. Do not let your emotions take over your investing style. By this I mean ‘Have a plan and trade the plan’.

Covered Call Options

In other blogs I discussed how to sell covered calls on stocks you own. There are various expiration months from which an investor can choose to sell. Selling covered call options provides some downside protection.

Example 1 – At the Money Call

If you buy INTEL (Ticker INTC) at $22 on October 1st and choose to sell the ‘At the Money’ November $22 call (1.5 months away) you can collect a premium of approximately 60c. This will provide 2.7% protection (being 60/2200) on your capital invested in the shares you bought at $22. The return on investment if called out is 60c or 2.7% being ($22+$0.60) – $22 = $0.60 profit.

The equivalent Annualised return is 2.7%/1.5*12= 21.6%. What this means is if you repeated this return over a full 12 month period you would earn 21.6%.

This is 21.6% profit that you get whether or not you make any profit on the actual share price as well! I prefer to look at that 21.6% as my insurance , in effect my shares could go down by 21.6% and I wont have lost any money.

Imagine making 21% profit on your shares even if their price doesn’t go up !

Example 2 – In the Money Call

In The Money covered calls provide more protection from downside moves. If we choose to sell the Nov $21 ITM Call we could collect a premium of $1.30. This will provide 5.9% (being 130/2200) protection (being 130/2200) on your capital invested in the shares. However, the return on investment if called out is only 30c or 1.36% for the month being ($21+$1.3) – $22 = $0.30 profit.

The equivalent Annualised return is 1.36%/1.5*12= 10.9%.

So you can easily see the trade-off which exists. When you opt for higher protection your return on investment decreases. Personal preferences will determine which you choose. Some investors will tend to favour the higher annualised return trade. Some investors will favour the more conservative route. The choice is yours.

Obviously the more times you sell the call the lower your net cost on the share becomes. You can in theory own the share for free in less than 5 years using the above examples.

I tend to sell In the Money calls at times of higher risk such as when earnings may be due to report or if either the stock’s chart or the overall market issues sell signals.

Time is Money in Investing

You will be aware at this point that the further out in time you choose to sell your covered call the higher the premium collected and hence the higher the % capital protection. However you will also note your annualised return on investment will decrease the further out the calendar you move. See below example 3.

Options Trading for Beginners Guide - Covered Calls and Puts - Sellers of Time
Options Trading for Beginners Guide – Covered Calls and Puts – Sellers of Time

Example 3 – Longer Term Calls

One final example on using covered calls for protection would be to choose to sell the Jan 2013 $21 call (ATM). The premium on offer today for this call is $1.60.  This is 3.5 months away.

This will provide 7.3% protection (being 160/2200) on your capital invested in the shares which were bought at $22. The return on investment if called out is 60c or 2.73% for the 3.5 months being ($21+$1.60) – $22 = $0.60 profit.  However, the annualised return drops to 2.73%/3.5*12= 9.36%.

In summary, covered calls can provide limited downside protection. It is important to consider the impact on the return on your investment before deciding on which call strike and expiration month.

Note: Returns above exclude any dividends which would be earned if one holds the shares. In reality as well as a good options income of 20% per annum I would expect decent returns on the stock price in the region of at least 5% and dividends of around 3% per annum as well.

Put Options – Protecting Your Investment

One very direct method of protecting your shares is to purchase or buy a put option.

Recall the Put Option Definition – A put option gives the owner the right, but not the obligation, to sell stock at the strike price for a limited time, namely up to the expiration month third Friday.

Unlike using covered calls (which we sell to open) for protection to gain protection from put options we need to BUY the put option. That means we pay for something which costs us money.

How to do a Put Option

The INTC November $21 put option would cost us approximately 30c. This would mean we would pay 1.36% for 1.5 months protection. The protection in this case is not 100% however. If we select the $21 put it means we could sell our shares at $21. However, we paid $22 for the shares so this would mean we would lose $1 ($22-$21=$1). The maximum loss would be $1.30 ($1 loss if we exercise plus the $0.30 premium paid for the put option). This would represent a loss of 5.9%.

Let’s say the share fell to say $18 in the month. What is the benefit of the protection put? We can simply turn to the market and request our shares are put to the market at the strike price agreed which was $21 per above. This means the protection provided to us was $3.00 per share.

How to do A Put Option to Make Extra Money on Your Stocks

The At The Money put option will give us greater protection but it will cost more.

The INTC November $22 put option would cost us approximately 60c. This would mean we would pay 2.7% for 1.5 months protection. The protection in this case is almost 100% however. If we select the $22 put it means we could sell our shares at $22. This is the same price we paid so we would lose no money if we exercise our rights and sell the stock at $22 at some point between now and the 3rd Friday in November.

The maximum loss would be $0.60 the premium we paid to buy the put option. This would represent a maximum loss of 2.7% before we include any dividend income (versus 5.9% in the above example).

Options Trading for Beginners Guide - Covered Calls and Puts - Get Paid Twice

Let’s say the share fell to say $18 in the month. What is the benefit of the protection put? We can simply turn to the market and request our shares are put to the market at the strike price agreed which was $22 per above. This means the protection provided to us was $4.00 ($1.00 more than Example 1).

You can see clearly the ATM put option gives us greater protection from a downside move but it costs more. Obviously you cannot keep buying insurance each month as it would make it difficult to earn profits.

We are usually sellers of time not buyers!

Put Spread Options in Investing

To reduce the cost of the put protection, which is often referred to as a form of ‘insurance’, we can buy a put spread or a ‘married put’ on shares we own. We are ‘marrying’ the put spread with the shares we have bought.

The advantages of put spreads are they are lower in net cost to open and we can gain protection for a longer period more economically. The disadvantage is they do not provide 100% cover. However, such cover is rarely required in practice on top quality stocks.

How to do a Married Put Option

After buying the shares at $22 we buy the April 2013 $22 put for $2 and sell the $21 put for $1.50. This would protect us from a $1 drop in INTC for a cost of 50c ($2-$1.50=$0.50). This would offer protection for 6.5 months.

We know we can collect rent on our shares for next month at the Nov $22 call strike of 60c now. This will pay for the insurance cost of 50c and leave 10c profit in our first month of rent. We have 6 months to collect rent and dividends while the insurance cover down to $21 remains intact.

During this time we could then sell covered calls to generate income and collect dividends knowing we had $1 of insurance. Of course we could choose a wider put spread such as the $22/20 put spread which would give us more i.e. $2 of protection. Note this would cost more to open though.

Options Trading for Beginners Guide - Covered Calls and Puts - Married Puts

There are many different combinations of put spreads to choose from. Again, the one which is right for you will depend on your risk tolerance and return targets.

Note: The put spread can be closed at any time up to expiration. If the share price drops after you open your put spread you will likely find the put spread position could actually be closed for a profit. Hence, if you feel the share becomes oversold you could then close out your insurance, lock in the profit, wait for the share to rise then reopen insurance (possibly for a different expiration month).

Leap Puts – ABC Investing Strategy

ABC Strategy = Acquire the share, Buy the Insurance, Collect rent

There is a method of insurance called LEAP puts. These are put options which have an expiration date more than one year away. You can buy them just like you would any put option.

The strategy we use here involves buying our share, then buy our ‘insurance’ being the LEAP put which in this example would be the Jan 2014 Put option.

The put strike we tend to favour is the strike price which is almost 50% higher than the current price. This is because the cost per month in time value is very low at this level. Also, many shares do not move more than 50% in one year.

We do not go higher than this 50% level as it becomes too capital intensive which reduces our income yield.

LEAP Puts Options

While we have the insurance in place we go about the normal business of selling covered calls on our stock. Ideally we sell calls at resistance. This reduces the risk of being called out and losing our shares.

We do not wish to be called out. Remember we have an insurance contract. Not much point paying for car insurance if you have no car! Unless you want to lose money!

One way to avoid this situation is to sell call spreads instead.

Investing – Selling Call Spreads

  • Step A) We Acquire or buy 100 INTC at $22 in October 2012. Total Cost $2200.
  • Step B) we Buy the Insurance at say Jan 2014 $35 Put strike is $14. Total cost = $14×100= $1,400.
  • Step C) When we Collect Rent by selling a call spread, for example we could sell the INTC Nov $22 call for 60c and buy the Nov $23 call for 30c. This would yield a net 30c income or 1.36%. One option covers 100 shares. Total net income is $0.30×100=$30.

Remember owning a put option means we can sell the share at the put strike price we bought anytime up to the put expiration month. In the example above, if we buy the share for $22 and buy insurance for $14 then our total cost is $36 per share or $3,600 total outlay. As we can only exercise to sell the share at $35 the difference of $1 is the time value we have paid. Jan 2014 is 15.5 months away.

Our insurance cost per month in time value is $1.00 / 15.5 = 6.5c per month. Our covered call spread above yields 30c net in month 1.

If you opt for calls instead of call spreads please be sure to continue to own the shares. In this case it is wise to consider Out of the Money covered calls, for example the Nov $23 call for 30c.

Investing – How Call Spreads Work – example 2

  • If called out the share will have risen from our purchase price of $22 to over $23.
  • Get back into the share as soon as possible unless the share has moved to overbought status. But do set a limit to how far you let the share rise before taking action (even if in overbought).
  • If you have been called out then set limits (using technical analysis) for yourself in terms of how far you let the share price rise before stepping back in to buy the share again.
  • Once you rebuy share then sell calls again. You have 15 months of protection.
  • Please note the LEAP put, like all puts, will decrease in value if the share price rises.
  • We are not overly concerned about this as long as we are in control of the share (i.e. we own the shares).
  • Do not let months pass by without owning the share as you will effectively be short the stock by owning a LEAP put. You will lose money as the share price rises if you do not own the shares!

In INTC example the annual dividend is 90c. Thus the dividend alone almost covers the insurance cost in time value ($1.00 above).

Note: You do not need to be greedy by selling aggressive ATM calls (such as the $22 strike in our INTC example). There is a much higher chance you will be called out at $22 than $23. Then you will be under pressure to get back in.

Call Options – Locking In Profits – Example 3

  • Please note if you are not called out of your stock and you do not have an open covered call position you always have the option to put the shares back to the market at the strike price of your insurance LEAP put.
  • Say INTC is trading at $21 in December 2013. By now you should have collected 90c in dividends plus several covered calls rent, let’s estimate you sold 12 covered call spreads for 30c during the year (out of possible 14). Here you have collected $3.60 in rent plus $0.90 in dividends which is $4.50 income.

What is your net position?

  • Share cost $22+insurance cost $14=$36 (Total Outlay per share)
  • We can sell the shares at $35 by using our put option rights (recall we bought the $35 put).
  • Sell shares at $35 plus income received of $4.50=$39.50 (Proceeds)
  • Profit = $39.50 – $36.00 = $3.50 or 10% return while 100% protected on the downside. We often trade our insurance puts and sometimes turn it into a spread to improve the return %.

Note: This form of insurance protects you 100% on the downside (excepting the time value cost of $1 in the example above).

Please use my standard excel model for tracking and modelling your positions using the ABC strategy to understand your profit at various points.

Married Puts – Investing How To

Please note one further method of capital protection is what is called the ‘married put’.

  • This method of insurance simply involves buying the share and then buying a put at a strike which is near the price you paid for the share.
  • Unlike the ABC plan we do not opt for a strike price which is 50% higher than the share buy price.
  • The time period can be whichever you choose.

Investing – Married Put Options – Example 1

  • Let’s Buy 100 shares of Waste Management on Dec 18th 2012 at $34
  • Then we select the expiration month and strike price for the put option (insurance) which we will buy.

The choice of put month expiration depends on two considerations:

  • Firstly, how long do we wish to tie up capital in the investment? If it is only for say 4 months then we will only look at put options as far out as April 2013 and
  • Secondly, the further out in time and the closer the strike price is to the share price the higher the time premium we will have to pay for the insurance protection
  • Let’s Buy the April 2013 $34 put at $1.40
  • This represents a % cost of 4.1% for 100% downside protection for the next 4 months.
  • Recall the purchase of the put option insures we can at any stage sell our shares at the put strike of $34. For example, imagine the stock market crashes and the share price of WM fell to $30. Instead of having lost $4 or 12% we simply exercise our put option and can sell the shares at $34.

Hence we are fully protected and all we lose is the cost of the insurance policy.

How do we make money using this married put options strategy?

  1. If the share rallies above $35.40 anytime before April expiration we are able to close out at a profit. The breakeven price of $35.40 is the original $34 share price plus the insurance put bought at $1.40
  1. We collect dividends on our stock while we own it. Yield is 4% per annum.
  1. We could sell Out of the Money covered calls to generate some rent up until April 2013. For example we can sell the Jan 2013 $35 call if the share rises to lock in some income in the full knowledge we are protected against a price drop. Ideally we would manage to sell a call each month which would amount to an income in excess of the insurance and then we could also sell the shares above the price at which we bought originally.

How to do a Married Put Spread – Example 2

  • Let’s Buy 100 shares of Waste Management on Dec 18th 2012 at $34
  • Let’s Buy the April 2013 $34 put at $1.40
  • Let’s Sell the April 2013 $30 put for 35c
  • This represents a % cost of $1.05 or 3.1% for 12% downside protection for the next 4 months or 100% protection on the way down to a price of $30.
  • Hence we are not fully protected but in most good quality stocks this insurance will prove adequate except for times such as the financial crisis.
  • Personal risk tolerance will dictate which approach you take.

How do we make money using this married put options strategy?

  • Same as previous example except this time the insurance cost less which adds to our profit potential on the investment.
  • Please note this version of the protection does not eliminate downside risk as in the previous example but it does provide significant protection.
  • Technically this married put example may be more accurately described as a married put spread as in the put spread is married to the share we bought.

Investment Skills – Market Timing

A more general form of capital protection is to try to time making your investments. The old rule of thumb is to Buy at Low prices and Sell at High prices.

This is easier said than done for most investors. Why? Most investors do not control their emotions, especially fear and greed.

Emotions overcome the average investor who panics when prices fall and is greedy when prices rise.

  • The fear often prevents you from buying at the low prices, because you believe the prices will fall even more and
  • The greed often prevents you from selling at high prices, because you believe the prices will rise even further
Stock Market Timing

This is what we refer to as the Market Rollercoaster. Master your emotions and you will become a more successful investor.

Technical analysis (which I cover in huge depth in one of my other blogs) helps us to time our investment entry and exit points. Remember we aim to buy shares when the stochastics indicate they are in an oversold condition and other indicators confirm a buy signal.

We aim to sell our stocks when the stochastics are indicating an overbought condition exists and other indicators provide confirmation of a sell signal. See my Technical blog.

Dollar Cost Averaging & Position Sizing in Investing Stocks

Another more general form of capital protection is to average into your desired stock holdings over time. We discussed this at the beginning of this module under the Portfolio Building section.

Do not buy your full allocation of any share in one trade. Very rarely will you buy at the exact bottom. Very rarely will you sell at the exact top price either! In the Traders Lounge we refer to this as dipping your toes into positions.

To be successful you only need to be buying and selling in the correct ranges.

Rule of Thumb for buying stocks at a low price

  • Average into your desired quantity of shares over three purchases. The timing is up to your personal choice but will be affected for example by specific news from a company such as earnings or guidance which is better than expected. If so you may need to act sooner than you had planned. You should never feel that you simply must buy now however! Keep control of your emotions. Remember your Diversification Plan!!
  • No matter how sure you may be that a stock will go up please keep all positions limited in size relative to your overall portfolio. This will let you sleep well at night and avoid worrying about your account should you buy a share (without insurance) which falls in price.
  • If you over expose your account to one single share or position you may not be able to emotionally withstand a drop in value (even if temporary) and be unable to wait for a recovery in the price.

Investing INSURANCE using Call and Put Options – SUMMARY

  • Make sure you have adequate insurance to avoid panic selling at loss when market hits speed bumps!!
  • Remember it is critical you protect your capital in times of volatility especially. Do not get complacent.
  • Risk management is essential to running any business effectively
  • You do not drive your car without insurance, why would you invest without insurance?

6. MULTIPLE CHOICE TEST QUESTIONS ON PORTFOLO DESIGN AND CAPITAL PROTECTION

Q1.  Should one plan for Financial Freedom?

  1. Yes
  2. No

Q2.  Which of the below is generally regarded as a sensible approach to building a portfolio?

  1. You should put all your eggs in one basket
  2. You should bet all your funds on the one horse
  3. You should diversify your investments across different asset classes

Q3.  Based on Value Line research which Timeliness rank stocks perform better over time?

  1. Rank 1
  2. Rank 3
  3. Rank 5

Q4.  Which of the following actions would be taken in order to insure or protect your investment in a share?

  1. Sell a Put Option relating to that share
  2. Buy a Put Option relating to that share
  3. Buy a Call option relating to that share

Q5.  Which of the following refers to a strategy designed to own share for 15-20% discount to the current price?

  1. Covered Call
  2. Barney Rubble

Q6.  Which of the following is true?

  1. Selling an At The Money Covered Call provides more protection to the downside than an In The Money Call option
  2. Selling an In The Money Covered Call provides more protection to the downside than an At The Money Call option

Q7.  Which of the following is true?

  1. The owner of a put option can sell the stock at a certain specified strike price no matter what the current market price of the share is
  2. The owner of a put option can buy the stock at a certain specified strike price no matter what the current market price of the share is

Q8.  Which of the following is key to making profits ignoring options?

  1. Buy High and Sell Low
  2. Buy Low and Sell High

Q9.  Which of the following strategies is designed to give maximum downside protection?

  1. Barney Rubble Strategy
  2. Covered Call Strategy
  3. ABC Strategy

Q10.  Which of the following strategies is recommended when building a portfolio?

  1. Buy all the shares you desire in a company all at once
  2. Dollar Cost average your way into a stock as it price falls

MODULE 6 – Correct Answers

  1. a
  2. c
  3. a
  4. b
  5. b
  6. b
  7. a
  8. b
  9. c
  10. b

Results Grade

A:  If you score 9 or 10

B:  If you score 7 or 8

C:  If you score 6 or lower.

Please read through the text section relating to the questions you answered incorrectly.