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Options Trading for the Institutional Investor: Setting the Ground Rules

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Michael C. Thomsett outlines the five underlying assumptions that this book follows—ground rules to keep in mind because they relate to your risk profile and investing philosophy.
This chapter is from the book

This book explains how conservative investors can employ options strategies to (a) enhance current income without increasing market risks, (b) protect long positions through options used for insurance, and (c) create a form of contingency to survive in volatile market conditions.

The Ground Rules

Because you are a conservative investor, the arguments in this book are based on a series of underlying assumptions. Always keep these ground rules in mind because they relate to your risk profile and your investing philosophy. This book follows five underlying assumptions:

  1. You will limit options activities to stocks you have prequalified. This is a necessary starting point, as long as your portfolio and the stocks you use for options strategies include stocks you believe in as long-term-hold positions and you consider these stocks permanent parts of your portfolio (as long as the fundamentals remain strong). This is an important attribute because it is not conservative to buy stocks solely to use for options strategies. A conservative approach to options must include the premise that your activities will be limited to the strongest possible stocks you can find.
  2. You believe that your stocks will rise in value. A conservative investor naturally expects stocks to rise in value; otherwise, why keep them? But this seemingly obvious point has relevance in the underlying assumptions of this book. Many of the discussions of strategies are premised on a belief that, over the long term, the subject stock’s market value will rise. However, many options strategies work best when stocks do not rise, such as in bearish combinations or long put strategies. Covered call writing (a very conservative strategy) is most profitable when stock values remain steady or even fall slightly. This means that you may need to time a strategy to produce profits resulting from short-term stability in prices, hoping for longer-term growth. So a second underlying assumption is in line with the conservative approach. This means you want to accumulate shares of value investments, you expect prices to rise over time, and you will change a hold to a sell when the fundamentals change. However, at the same time, some options strategies are designed to take advantage of short-term price volatility. When marketwide volatility affects short-term prices of your stocks, you have an opportunity to pick up discounted shares, take profits (without having to sell stock), or average down your overall basis. Of course, the proposal that you should average down is conservative only if the basic stock selection assumptions remain valid. You want to employ such a strategy only for stocks in which you have a strong belief as long-term value investments.
  3. You accept the premise that fundamental analysis of stocks is an essential first step in the process of examining option opportunities. Options have no fundamental attributes. These are intangible contractual instruments, and they have no value on their own; thus, you can judge the tangible value of stock only as a means for selecting appropriate options strategies. Many first-time options traders make the mistake of overlooking this basic reality. They select options (and stocks) based on the immediate return potential, but they ignore the real market risks of the underlying stocks. This violates the conservative tenet that stocks should be chosen for their fundamental strength and growth potential.
  4. In the event of a temporary downward movement in a stock’s price, you would be happy to buy more shares. Some investors might be unwilling to pick up more shares of a particular stock, even when the opportunity to buy discounted shares is presented. This book introduces several strategies proposing that additional shares be purchased (or exposed to contingent purchase) using options. If this is not the case in a particular situation, you should simply pass over those suggestions. You might use a strict formula for diversification or asset allocation to limit risks in particular stocks, for example, so strategies aimed at increasing your holdings in one stock might contradict your portfolio management standards in such an instance. Strategies proposing that you pick up more shares work only if that suggestion conforms to your overall portfolio plan.
  5. You believe that an adequate number of available stocks meet your criteria. Some investors become convinced that their short list of stocks is the only list available to them. Thus, if they sold shares of stock from their portfolio, they would be unable to reinvest profits in equally acceptable stocks. If you do not believe this, you are probably aware that dozens of stocks meet your criteria in terms of price level, P/E ratio, volatility, dividend payment history, and a range of other analytical tests. Accordingly, if you sell a particular stock from your portfolio, you recognize that you could (and would) purchase a number of other stocks that also conform to your criteria.

Incidentally, this practice makes sense whether you trade options or not. The fundamentals can change for any company, so if a hold stock changes to a sell, you need to reinvest funds. As a matter of basic portfolio management, every investor needs a secondary list of stocks for replacing sold stocks from the current portfolio. The need for maintaining this list relates to options trading because some strategies result in selling shares of stock. In those cases, you want to reinvest capital in a new issue on your list of qualified stocks.

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