Enhanced Portfolio Construction
Constructing an equity portfolio from scratch begins with buying one or more securities, but is now the right time to be entering the market?
Guessing day-to-day market movements is a fool’s errand, but you have to start somewhere, so focus on what you can control rather than what you can’t. Top of the list is how much cash you have to invest, and how much you can afford to lose. Next is what you feel comfortable owning, and why – is it because of the company’s historic earnings, its dividend, its market segment, or its management’s other priorities?
Now that you’ve identified the first stock you want to buy, it’s decision time – buy at the market price, place a bid below the market in the hope that it comes down a little, or buy some now and add some more if the price comes down.
But assuming you want to start investing today, there’s another way you might want to consider. Instead of buying the share today, you could sell a put option on the share you want to buy and get paid to wait.
Let’s look at a real-world example, Shell Plc, and compare.
Shell Plc – Trading at 2353p 15th Nov 2022.
Buy the equity
You buy 2,000 shares at the market price of 2353p. You are now holding £47,060 of Shell Plc. If the shares go up, you make money and if they go down you lose money. Obviously if they stay at 2353p you neither make nor lose.
Selling a put
You sell 2 put contracts with a strike price of 2350p with an expiry date of 16 December 2022 and receive a premium of 71p each. One contract equals 1000 shares so you have sold puts based on 2,000 shares. You receive 71p which equates to £1,420 (0.71p x 1000 shares x 2 contracts). This is 3% of the value of the shares for an option which only has 5 weeks until expiry.
If the put is assigned, you’ll be obligated to buy 2,000 shares of Shell at 2350p.
Scenario 1: Shell Plc shares go up and are above 2350p by expiry
The options you have sold expire worthless and you keep the £1,420 premium which is a 3% return in 5 weeks.
If you want, you could repeat the exercise. Each and every time you sell a put, and the price goes up, you are earning income which can be used towards buying the shares if and when you have to buy the shares (when Shell Plc’s share price falls below the strike price of the put option you have sold).
There is however an ‘opportunity cost’ of this trade. If the price of Shell shares goes up more than 3% (i.e., more than 71p), you will not benefit from any further increase above the 71p premium you have already received.
Scenario 2: Shell Plc’s share price falls and is trading below 2350p by expiry
The option is assigned, and you have to buy the shares at 2350p. Taking into account the premium collected, you would own the shares at 2279p (2350-70) which is a 3% discount to the price you would have paid if you had bought the shares on day 1.
Owning shares through assignment: 2,000 shares x 2350p – £1420 premium = £45,580.
Scenario 3: The stock trades sideways and is trading at 2350p on expiry
You can buy your option back for a fraction of what you sold it for 5 weeks ago (now trading at say 7p, for £140), locking in a profit of £1,280 (2.7%) in 5 weeks.
If you are still interested in buying the shares, you could then repeat the same process again.
Market direction will always have the biggest part to play in the outcome of your stock portfolio.
Options are a very useful tool because you can enhance your profits and limit your losses, whichever the way the market moves.