Options Can Boost Retirement Returns

BOSTON (TheStreet) - For many investors, options trading is a numbing jumble of complex strategies and foreign jargon.

But, according to Randy Frederick, director of trading and derivatives for Charles Schwab ( SCHW), investors who cut through the confusion can find a valuable approach for diversifying their retirement plans and hedging against turbulent markets.

"Options will never be as simple as equity trading or mutual fund investing, Frederick says. "The key is to learn as much as you need to know to be effective using these strategies, but not flood yourself with all this information that you really don't need to know."

At their simplest, options are contracts that give investors the right to buy or sell a security at a certain price. Call options give the holder the right to buy a specified number of shares of stock at the strike price at any time until the contract expires. Put options give the holder the right to sell a specified number of shares of stock at the strike price until the contract expires.

A buyer can choose to buy or sell the underlying equity, sell the option, or allow it to expire worthless. Sellers have an obligation to act on one of those same scenarios. A "short put," enables the selling of a put without owning or shorting the underlying instrument. If it reaches the strike price, the issuer earns the premiums sold on the option. If the stock drops below strike price, the shares must be purchased, usually at a favorable price and with premiums intact.

Frederick advocates a conservative approach to options, deploying them as an alternative to the skimpy yields of many bond investments. You won't break the bank and you can maintain a steady return of a couple of percentage points a year with rare losses.

"Slow and steady wins the race," he says. "That doesn't mean you will always eliminate all your losses, but even in a really awful market, like we had in 2008, the proper use of very conservative options strategies could have cut losses in half, if not more."

Options aren't without risk. Investors can lose money on options if the value of the targeted security appreciates beyond the strike price. Still, the tax benefits of individual retirement accounts, or IRAs, makes them a natural vehicle for deploying options strategies, Frederick says.

"It is a great way to be in a small-income generating mode while at the same time picking up stocks that you want to own at really good prices."

One retirement strategy he promotes involves short puts.

"IRAs tend to be accounts where people find some stocks that they like, put a bunch of limit orders on and just sit there until they come down to the price that they are willing to pay," Fredrerick says. "Short puts are a preferable alternative. If those stocks come down to those strike prices by expiration, you end up buying the stocks at a favorable price, plus you keep the premium you sold the option for. If they don't come down to your price, the options expire and you keep the premium anyway."

There is one potential drawback. If you enter a limit order and the stock comes down to your limit price at any time, it will get executed and filled. If you sell a short put at a price you are willing to pay for a stock, it has to be below that price on the expiration date. If it drops below before the contract expires and then comes back up, you may miss out on the opportunity to buy.

-- Reported by Joe Mont in Boston.

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