In this 4-part series (concluding next Friday), Ben Reynolds, CEO and editor of Sure Dividend, highl...
Versatility, Flexibility: The Continuing Allure of Listed Options
01/22/2018 6:00 am EST
Sure, some option strategies can be complex, and the knowledge and sophistication of the investor must keep up. Young investors are well-positioned to embrace options for flexibility and versatility, writes Scott Connor, Director of Trader Education, TD Ameritrade.
In 2018, the exchange-traded equity options market will celebrate its 45th anniversary in the U.S. Though 2017 marked another year of historically low volatility, with an average daily volume of 16.7 million contracts, the year still ranked among the top three ever, according to data from the Options Clearing Corp.
Why has options volume been so resilient despite the lack of volatility? It’s due in part to a growing appreciation for the versatility of listed options. Whether you’re a small, self-directed options trader or a large institutional investor, there are a number of option strategies that may help you pursue your investment objectives while staying within your risk parameters.
Here come the millennials
Though TD Ameritrade has seen volume growth in options trading in all client groups, including millennials, millennials are the first generation to grow up immersed in technology, and they’re also known for being value-driven. So, as today's young adults become investors, trading options on a robust online platform seems only natural.
Of course, options trading isn’t suitable for everyone, but if you think they might be right for you, there are some basic option strategies that can be used to accumulate shares, help protect an existing investment or even to enhance the yield of a stock position you hold. Here are a few strategies popular among TD Ameritrade clients who trade options.
Basic option strategies for the new investor set
1. Buying calls as an alternative to buying stock. A call option gives the owner the right, but not the obligation, to buy the underlying security at a specific price (the “strike” or “exercise” price) on or before a specific date (the “expiration"). Since the premium paid for a call option is usually a fraction of the stock price, and since call option prices typically rise/fall when the price of the underlying stock rises/falls, many consider this a lower-cost alternative to buying a stock outright. But beware of the risks. Stocks don't expire, but options do, and if a call expires out-of-the-money, the entire investment in the option will be lost. Plus, owning a call option doesn't give you voting rights that owning the underlying stock would, nor will it pay a dividend. Once you exercise an in-the-money call option, however, you become the buyer of 100 shares of stock.
2. Selling calls as a potential yield-enhancement. Investors who own a stock and wish to potentially earn income can sell a call and receive a premium. In this "covered call" strategy, if the call expires out-of-the money, the seller keeps the premium they received, less transaction costs. The risk, of course, is if the stock price rises above the strike price any time on or before expiration, the call owner may exercise the option, and the seller will be required to deliver the stock at the strike price, effectively limiting the ability to benefit from any additional appreciation of the stock price.
3. Buying puts for protection. While the covered call can potentially enhance the yield of a long stock position, buying a put option can limit possible losses if the stock price were to fall. A put option gives the owner the right but not the obligation to sell the underlying stock at the strike price, so owning a put option essentially provides a temporary price floor, below which losses are limited. Of course, like the long call option, if the long put expires out-of-the-money, the entire investment in the option will be lost. Many option traders consider puts during times of elevated market risk, such as before the release of an earnings report or other company announcement.
4. Selling cash-secured puts to build or add to a portfolio. If you want to use options to potentially buy stock, but you would rather collect premium than pay it, selling a put might be the answer. Why is it called “cash-secured?” Because you set aside enough cash in your account to buy the stock in case the owner exercises the option. Make sure you choose a strike at which you're comfortable buying the stock and understand that you’re taking on the risk of purchasing the corresponding stock at that strike price when the market price of the stock will likely be below that strike price.
Many TD Ameritrade clients, once they become comfortable with the basics, move up the sophistication scale. They use the advanced thinkorswim platform to assess relative values, consider risks and probabilities, initiate multi-legged option spreads and monitor positions in real-time.
Sure, some option strategies can be quite complex, and as complexity increases the knowledge and sophistication of the investor must keep up. But we believe the next generation is well-positioned to embrace options for their flexibility and versatility and can use the power of today's innovative trading platforms and free educational offerings to become those sophisticated investors.
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