Options can be a valuable tool within an advisor’s toolbox, but because of their potential complexity, they require a deep well of knowledge and understanding to navigate successfully. Options can provide portfolios with a wide variety of benefits if used correctly, and understanding the potential and the pitfalls will help advisors and investors navigate their usage better.
In a year where equities and bonds have all been challenged, options can provide several benefits for portfolios: they can be a means to generate income, they can be used to hedge portfolios, they can be used to leverage exposure, and they can add flexibility to a portfolio. While this is a basic overview, you can find more detailed information on puts and calls here or more information on in and out-of-the-money options here.
Options Use Cases
There are several reasons that advisors and investors seek out options, but they break down into four broad categories:
- Income generation- This has been one of the most popular use cases this year in a challenging environment for equities and bonds. Options can provide the potential for an additional income stream via writing calls, covered calls, or other strategies.
- Hedging- In an environment of prolonged market volatility, options have also been popular to hedge against excessive loss or even just to put guardrails around an investment. Puts and protective puts can provide the potential to mitigate a level of risk, an attractive prospect in bear markets particularly.
- Flexibility- Investing directly in stocks means money is only made if the stock price appreciates. Options allow investors to take positions on a stock rising or falling over a set period with the potential to make money, either way, the stock price moves.
- Leverage- Some advisors and investors use options to capture a stock’s performance instead of investing directly in the stock itself. Options are typically cheaper than direct investment, freeing up more of the portfolio for other allocations while gaining the desired exposure for less. It’s a tricky and difficult strategy, though, and requires knowledge and expertise and should be reserved only for the more experienced options investors or for funds that utilize options in leverage strategies.
Benefits of Using Options
Just as their use cases vary, the benefits of adding options to a portfolio are just as varied.
Investing in options can be less risky to invest money compared to equities — if done properly and carefully, with knowledge and understanding of options investing — particularly in a challenging environment like now. Options can cost less to invest in than buying into an equity stock, offering the potential to capture the majority of a stock’s performance for a percentage of the stock’s price. Options also work 24/7 and are not constrained by instances of sharp overnight declines that can lead to gap openings that equity securities are susceptible to. In the event of overnight volatility, an options investor with a put in place for a stock would only realize losses to the price of their put compared to the equity investor, that must absorb the full loss.
Options are also relatively cost-efficient compared to their stock peers. As such, some investors use them as a form of stock replacement, taking positions that they believe will best mimic the stock’s performance through calls for a margin of the cost. It’s a type of investing that requires deep knowledge and understanding of the options market in determining which contracts are the ones that would provide the desired performance outcome, but the cost-saving potential exists, and therefore increased return potential. Mismanagement of options in this use case can result in the loss of all of the investment without the potential of owning the stock to sell at the end of everything.
The Benefits of Using an ETF To Access Options
Options are dynamic and offer advisors and investors the ability to take various positions on stocks, whether hedging and enacting risk protections from volatility or seeking to replicate stock performance for less.
Investing in options through an ETF can take much of the hassle and headache of using derivatives for advisors. While it’s essential to understand what’s under the hood and how an ETF might be using options in its strategy, relying on an ETF that utilizes options can take much of the legwork and complications out of options investing.
ETFs are known for their liquidity and flexibility, and it’s no different for an ETF that utilizes options. Accessing derivatives through an ETF means you can pay a nominal fee to have a trained portfolio manager navigate the options market instead of going through a broker and navigating commission costs and options selection.
There is a range of ETF strategies that utilize options depending on the kind of exposure desired, but the most popular this year have been ETFs centered around income generation and risk mitigation/hedging. Most advisors are comfortable and familiar with the ETF structure and vehicle, and utilizing an ETF for options exposure can create greater confidence for advisors, on top of being easy to access and use within a portfolio.
For more news, information, and strategy, visit the Retirement Income Channel.