Options for RRSP and TFSA

It’s that time of year again, where investors thoughts turn to RRSP and TFSA contributions and taking advantage of growing their portfolio in a tax-sheltered or tax-free way.

There are many ways to approach portfolio management. Often, when you ask a cross section of self-directed investors their answers will vary. Some differences include:

Regardless of the differences, all successful investors tend to have one thing in common, an investment plan.  They follow a well-thought-out, ever-evolving set of guidelines that are based on personal risk tolerances and objectives. Furthermore, they include strategies that will help them manage their emotions, execute with discipline and help them reach their goals.

For many self-directed investors, these plans center around managing for their retirement and are based on taking advantage of a variety of tax-sheltered or “tax- free” account types with the following objectives in mind:

Despite all the investor education available, many people are still unaware that there are several option strategies are lawful within registered accounts.

The following strategies are permissible in registered accounts for Canadians and can be used as tools to help meet investment objectives:

• Purchase calls instead of buying stocks or ETFs
• Purchase calls to secure future purchase price
• Purchase puts instead of short selling stocks or ETFs
• Covered call writing
• Protective puts for hedging
• The Collar strategy for offsetting the cost of hedging

*For a more detailed description of each, simply click on the link associated with the strategy.

As mentioned earlier, these strategies can be considered as tools to be implemented as part of a trading plan. And like any tool, their effective and safe use is based on the “handler’s” understanding of how they work, when to use them and the associated risks, benefits and possible drawbacks.

However, for any master craftsperson, confidence comes with education and experience.  This is where participating in the wide variety of webinars and/or accessing the recordings available through your broker can get you off to the right start.  The Trading Simulator available on the Montréal Exchange website will also help with order execution and position management in a safe environment before applying the above option strategies in your registered accounts.

With all that in mind, let’s look at how an investor might consider using the permissible option strategies in their registered accounts.

Buying Calls and Puts

As a stock replacement strategy, long calls and puts allow the investor to speculate and ideally profit from a directional bias on a company’s shares or an option eligible ETF.  The buyer of a call option believes the share price of the underlying stock or ETF is likely to go up, while the buyer of the put option is seeking to profit from a decline in the share value.  In both cases, the investor is only required to put up a fraction of the value of the equivalent underling position. This provides an opportunity to leverage capital in the investment account. This is an important consideration as trading on margin, which is the typical approach to leveraging capital in a portfolio, is not permitted in a registered account.

Another advantage is that the option buyer can not lose any more than the premium paid for the option contract. This ensures a limited and identifiable risk exposure when the trade is executed, which can be considered before the “transmit trade” button is pushed.

When considering a bearish position on a stock or an ETF, it’s important to recognize that short selling is not permitted in a registered account. This limits the typical investor from participating in a bearish, or down-trending opportunity.  Put options allow the investor to take that bearish stance with intention of profiting on the decline in the underlying shares.

Buying a Call to Secure the Future Purchase of the Shares

Often, investors may see an opportunity in a stock they want to own based on today’s prices, and not have all of the capital required to buy the shares.  With a contribution of capital planned over the next few months, investors can buy the equivalent number of call options representing the number of shares they wish to own, having a strike price reflecting today’s price.  The strike price of an option contract represents a right or obligation to buy or sell the stock at that specific price.  For call option buyers, they are paying a premium and securing the right to buy the stock at the strike price of the contract.  Purchasing a call with a strike price representing today’s price, locks in that purchase price until the options expiration date. The investors will choose an expiration date that is in line with when they expect to will have the capital to buy the shares.  Regardless of how high the shares climb from the current price; the call option buyers can exercise their right and purchase the desired shares at the strike price selected.

For those of you who are not up on option fundamentals, one caveat the option buyer must be aware of is that options expire worthless if they are considered “out-of-the -money”. This means that if the underlying shares do not move sufficiently enough by the expiration date, the option contract will expire worthless.  Investors can buy, sell or exercise their contracts at any time before expiration to cut losses and lock in profits managing for this risk.

 Covered Call Writing

This strategy involves the purchase of shares, combined with selling a call option contract. The investor is paid a premium and takes on the obligation to deliver the underlying shares at the strike price of the written contract.

The intention is to generate cash flow by collecting premium on regular basis.  This serves to help reduce volatility in a portfolio and enhances income beyond the traditional approach.

Strike Price Selection

Investors must select the strike price and expiration date that best suits their objective. For example, writing a call option with a strike price close to where the stock price is presently trading (at-the-money) brings in the highest time premium for the expiration month selected, but limits the opportunity to participate in share price appreciation.  By selecting a contract with a higher strike, the investor can participate in the share appreciation but will collect less premium.

Expiration Month Selection

Investors selecting shorter term options tend to benefit from a higher annualized cash flow however this approach is more transactional, selling calls and possibly dealing with exercise and assignment on a more regular basis.

Further out months provide greater up-front premium as these options have a higher time value.  This approach is less transactional.

Once again, the investors approach will be based on what their objectives are and how active they wish to be. Commissions will also play a factor as the more transactional the approach, the more commissions are paid throughout the year.

Protective Puts

The protective put is also known as the “married put” and involves the purchase of a put option as a hedge against the risk of a drop in the value of shares that an investor owns.  In simple terms, as the share value drops, the put option will increase in value, off-setting a portion of the unrealized loss.

Similar to buying a call option, this strategy allows the investor to take a shot on an opportunity with a defined risk.  More importantly (in my opinion), it allows for several choices to be considered if the stock does sell off.  Knowing that for the lifetime of the option contract, the risk is defined and limited, investors filter out their emotions to decide if continuing to hold the stock or cutting the losses makes sense.

Further benefits:

Re-positioning

Investors can close the put at a profit and use the proceeds to buy more shares at the lower price, adjusting their cost basis

No volatility stop out

Unlike a stop loss, which will trigger as soon as the share price hits the stop loss value, the protective put remains in place. In addition, if using a stop loss to manage risk on the position, a pre-market or after market decline in shares (i.e. earnings report) below the stop loss value could result in the sale of the shares significantly lower than anticipated.  This is because the stop loss order is submitted as a market order when the stock resumes trading, which could be significantly lower than anticipated. The put option guarantees the sale of the shares at the strike price regardless of the drop and allows investors to close the position at their discretion instead of being forced out of the shares due to volatility.

Locking in profits  

Investors can use a put option to lock in profits.  As the share value approaches the investors price target, rather than closing the position, the investor can use some of the profits to buy a put option. This will lock in the profits less the premium while allowing the investor to continue to participate in any further upside.

The Collar Strategy

This is simply the combination of a covered call and a protective put. The intention is to use the premium collected from the sale of the call option to help pay for the protective put.

The rationale is that the investor believes that the risk of a sell off is more significant than the opportunity for further upside for a period. This allows the investor to add the put insurance at a reduced cost.

Be sure to refer to the strategy links provided above for a more detailed description and take a look at your brokers webinar schedule to find out when the next Montréal Exchange sponsored options strategy webinar is being hosted.

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.