Many investors regard options as risky or exotic investments, and, as a result, tend to steer clear of this asset class. But the fact is there are some very simple options strategies that can be utilized to manage equity portfolio risk. Particularly during periods of uncertainty and marketplace volatility, options can be a valuable tool for investors who wish to reduce their downside exposure while still affording themselves the opportunity to participate in market gains. Before discussing these strategies, let’s look at what options do.
There are two standard kinds of options––calls and puts. A call option gives the owner of the call the right to buy the stock on which the option was sold (the “underlying”) for a pre-defined price (the “strike price”) within a specified time period (the “expiration,” which takes place on the third Friday of each month).
A put option gives the owner of the put the right to sell the underlying for an amount equal to the strike price at any time prior to expiration. The price that the investor buys or sells the option for is known as its premium.
For example, an investor who owns 100 shares of Widget Inc. for $100, can sell the December 110 call option. Let’s say the price of the option is $9. The investor initially collects the $9 of premium. At any time between now and December expiration, the stock can get “called” away from the investor (remember, the investor sold the option in this example), and the investor would receive $110 per share for her Widget Inc. stock.
Since she originally collected $9 of premium, if the option is exercised she will have effectively sold the stock for $119 ($110 strike price + $9 premium). That’s a 19% gain. However, if the price of Widget Inc. goes to $150, she will not participate in any gains beyond $119, as the stock will be called away for $110.
On the other hand, if the price of Widget Inc. drops to $92 by December expiration, the option will not get exercised and she will hang on to her Widget stock for a net gain of $1 on the position, instead of a loss of $8. So the selling of the call option provided partial downside protection (down to $91 in this example; below $91, she would start to lose money on the position).
If instead the investor had decided to buy a put option, say the December 90 put for $11, she would now own the right to sell Widget for $90 at any time between now and December expiration. Even if Widget declined to $50/share, she would be able to sell it for $90. Since she spent $11 on the option initially, her total loss on the position would be $21 instead of $50.
Should the price of Widget rise, she would not exercise the put option and it would expire worthless. However, she will continue to own her stock and participate in all of the upside gains beyond $111 (since she spent $11 on the option to begin with, $111 becomes her “upside break-even” price in the stock).
The strategy in the first example is known as a “buy-write” (this investor buys stock, and “writes”, or sells, an upside call that is covered by the stock position. The investor could also simultaneously sell the call and buy the put, a strategy known as a “collar.” Using the prices above, selling the 110 call and buying the 90 put would cost the investor $2. Her upside gain potential would be 8%, and her downside loss would be capped at 12%.
While individual stock options can be used to offset portfolio risk, there are some disadvantages to this approach. First, if the investor is happy with her current portfolio of stocks, she is capping the upside potential of the winners in her portfolio. Second, she runs the risk of losing the position in some of the stocks she likes as they may be called away, which could also potentially cause negative tax consequences. Finally, managing a portfolio of equity options with varying expirations and strike prices can be quite time consuming and overwhelming for many investors.