How Can an Option Help My Stock Position?

05/23/2017 2:53 am EST

Focus: OPTIONS

Gary Delany

Director of European Marketing and Education, Options Industry Council

Sponsored Content—There is a tendency to see investment tools in isolation. Securities. Fixed income. Commodities. Foreign exchange. Some people even see derivative instruments as separate tools. There is a strong case to be made, however, that options are complementary to an underlying asset position.

In a nutshell, options can help change a risk profile.  They can help enhance returns, protect against a downward move, or give increased (or decreased) exposure to a specific group of stocks.

Impact on returns

The covered call is a well-known and popular strategy. See http://www.optionseducation.org/strategies_advanced_concepts/strategies/covered_call.html

The investor is holding a stock. She believes that the price will be neutral to mildly bullish. She writes a call option at a strike price (also known as an exercise price) slightly above the current market price (i.e. out-of-the-money). She hopes that at expiration the price of the underlying stock will be between the current market price and the strike price of the call option sold.

There is risk associated with writing a call option. The stock that is held and the option is written against may fall sharply in value. In this case the investor suffers that loss, which is offset to some extent by the premium that she has received. The other risk is that the stock that is held rises sharply in value and the call option that was written is now exercised, limiting the ability to participate in the rally. In this case it may make sense to buy back the call option sold (at a loss to the investor), so that the investor can benefit from any further rises in the stock.

chart 1

Limiting your risk

The stock market is said to be a mixture of fear and greed. If fear is the dominant sentiment and the investor is afraid that his stock portfolio will sharply decline in value, then he can offset the risk of loss by buying a put option. He can buy a put option with a strike price nearer or further away from the current market price of the stock. The farther the option is out-of-the-money (for a put, the lower the strike price is compared to the current stock price), the cheaper it will be. But it will also offer less protection, because the investor will have no price protection between the strike price selected and the current underlying stock price.

chart 2

For more details on this strategy, see http://www.optionseducation.org/strategies_advanced_concepts/strategies/protective_put.html

Potential to limit risk and reduce the total cost

Options are very flexible. In contrast to the simple buying or selling of an underlying asset, they offer a range of non-linear outcomes. They are also traded instruments, enabling the investor to trade in and out of option positions. You can add options to existing portfolios.

Let’s go back to the investor protecting a position with a put option. If a short call above the price of the underlying portfolio is added, then premium income would be received from the call sold, which would go some way to offsetting the cost of the put option that was purchased. The long put can be converted into a collar–buy an out-of-the-money put, sell an out-of-the-money call. The key thing to note here is that the call sold can reduce the total cost, but of course it cuts off some of the potential profit if prices spike upwards.

For more details, see: http://www.optionseducation.org/strategies_advanced_concepts/strategies/collar.html

chart 3

Collar study

The outcome of the collar strategy depends to a large extent on the strike prices chosen for the put purchased and the call sold. OIC has sponsored some research on collars, which can be found under the News & Research tab at www.OptionsEducation.org.

A summary of the findings is at   http://www.optionseducation.org/content/dam/oic/documents/literature/files/oic-collar-qqq.pdf.

In the study, Szado and Schneeweis of the Isenberg School of Management at the University of Massachusetts, found that a long protective collar strategy using 6-month put purchases and consecutive 1-month call writes earned increased returns compared to a simple buy-and-hold strategy while reducing risk by almost 65%. The period where the strategy was not successful (see chart below), was when stocks spiked during the dot.com bubble in 2000. 

Growth of $100 in Active and Passive Collar Strategies

chart 4

Source: http://www.optionseducation.org/content/dam/oic/documents/literature/files/qqq-collar-study.pdf, page 33
 
Index options
This web post has focused on options on stock. In addition, the US listed equity option markets list index options and ETF options. These can be used to move in or out of specific areas of risk or opportunity.

Conclusion
Options can be useful when used in conjunction with an underlying stock position or portfolio. They can be used to enhance returns and limit risk. When analyzing any strategy, investors need to consider risk and return: what is the worst outcome, and what is the best?

About OIC
The Options Industry Council (OIC) is an educational resource funded by OCC, the world’s largest equity derivatives clearing organization, and the US options exchanges. The mission of OIC is to increase awareness, understanding and responsible use of exchange-listed options among a global audience of investors, including individuals, financial advisors and institutional managers, by providing independent and unbiased education combined with practical expertise. 

Learn more about OIC at www.OptionsEducation.org.

Disclaimers:

The opinions expressed are the author’s own.

Options involve risk and are not suitable for all investors. Individuals should not enter into Options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org. None of the information in this post should be construed as a recommendation to buy or sell a security or to provide investment advice. ©2016 The Options Industry Council. All rights reserved.

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