Investors who held a traditional portfolio comprising primarily stock- and bond-based mutual funds took a terrible beating during the 2008 market rout
Investors who held a traditional portfolio comprising primarily stock- and bond-based mutual funds took a terrible beating during the 2008 market rout.
Those losses, along with continuing market volatility, have drawn investors to options — contracts that give their owner the right to buy or sell a specific financial product at a specific price until a set date in the future.
Investment adviser Michael Cavanaugh, president of Know Your Options Inc., a registered investment adviser, said options trading can boost portfolio returns while limiting risk and hedging market volatility.
“A lot of people got introduced to the stock market as a way to put away money, thinking that in so many years, they will have a certain amount more. But stocks have done nothing over 10 years,” said Mr. Cavanaugh, who added that many investors are now disillusioned with the buy-and-hold approach.
“I won't just wait for it to happen; I'll try to make it happen on my own” is the attitude of many investors now, he said.
“From my seat,” Mr. Cavanaugh said, “it is not a mystery as to how big investors get yield — they use options.”
BUY OR SELL
While exchange-traded options have been around for almost 40 years, many investors still have only a rudimentary understanding of the basics. Call contracts give the owner the right to buy, and put contracts the right to sell, an underlying security — typically, a stock or an index — at a set price until the contract's expiration date, which is always the third Friday of the expiration month. The so-called strike price at which the security can be bought or sold can be higher or lower than the underlying security's current value.
The market for options contracts has increased steadily, according to The Options Industry Council, a trade group of the options exchanges. During the first half of the year, 2.2 billion options contracts changed hands, up 10.3% from the comparable period in 2010.
While options are not for everyone, investors wishing to wring extra income from their stock holdings, hedge against market volatility or limit potential market losses can find them useful, Mr. Cavanaugh said.
“If an investor is in their accumulation phase and is 30 years away from tapping into his portfolio, options may not make sense,” he said.
But in the distribution phase, it gets “more interesting,” he added, because investors can use options to mitigate the risks of holding equities.
Options are an enhancement to a portfolio, “not an all-or-nothing thing,” Mr. Cavanaugh said.
One common income strategy for investors who own shares of a stable stock is to sell one call option contract per every 100 shares owned, he said. The contract gives the buyer the right, but not an obligation, to buy those shares at or before the expiration date at the contract's strike price, a certain amount above the current price of those shares.
If the share price surpasses the strike price, the stockholder is obligated to sell the shares to the buyer. Typically, the more “out of the money” the strike price, the lower the cost of the contract. Mr. Cavanaugh said that a typical strategy is to price the contracts to yield about 25 basis points for each month of the contract, or an annual rate of 4% a year.
Options contracts typically are traded on the Chicago Board Options Exchange or the International Securities Exchange LLC.
In such a deal, the owner of the stock gets a 4% return on the shares without selling but risks losing some of the profit if the share price rises enough to trigger the buyer to call the shares. For this reason, it is important to trade call options on shares of a stable company that aren't prone to wide price swings, Mr. Cavanaugh said. “You have to be sure your analysis is sound,” he said. “It is imperative to have a good stock you want to own.”
Another caveat is not to get too greedy.
“In a low-interest-paying environment, if you are shooting for 12%, you increase the probability of having to make an adjustment” or sell the stock at the agreed price, he said. “The further you go out of the money in selling the call, the less premium you get and the fewer adjustments you will have to make.”
SOME ADVISERS WARY
Some advisers shy away from using options, even when they might be helpful, Mr. Cavanaugh said. He said there are a variety of reasons for that. Some brokerage firms believe options are too risky, and they prefer that their advisers stick to mutual funds. In other cases, advisers feel that the commissions they receive on options trades are insufficient to compensate them for the work involved in crafting and monitoring options strategies.
Mr. Cavanaugh's firm bases its charge on a percentage of the value of the options.
“You can see the retail investor educating themselves about options,” he said. “Advisers who understand this and say, "We can help you,' will have an advantage.”
Email Lavonne Kuykendall at lkuykendall@investmentnews.com
