by Michael A. Cavanaugh
Michael A. Cavanaugh is president of Know Your Options (knowyouroptionsinc.com). He operates as a registered representative and as an investment adviser for the Discretionary Option Spread Strategy (DOSS) program. He worked on the floor of the Chicago Board of Trade as a broker and a floor trader from 1997 to 2003, and beginning in 2003 he brokered futures and options on futures for individual clients and professional investors off the floor.
The first option contracts were created more than 2,000 years ago, but only in the past 40 years, have they gained widespread popularity. With the advent of listed options being traded first in the open outcry venues of the exchanges and now electronic trading platforms, options are a product many advisers are no longer unfamiliar with. Indeed, many advisers would argue that options are too risky. Before we put a label on options, let's explore some reasons why options carry a perception of risk, and how options can be used to hedge risk, letting you decide if options are tools to hedge risk or devices that create unwanted risk.
A Reputation of Risk Thanks to Leverage and Time
First, let us look at why options have been perceived as too risky. I believe there are many reasons for this label, but the two main reasons for this perception are leverage and time.
The risk-and-reward profile of a stock is binary; if you buy a stock and it goes up or down you will make or lose money according to the amount of shares and the variance of the move. If you buy stock on margin (Regulation T), you have doubled this binary effect. You have twice the potential of risk and reward, and you are now paying interest on the money borrowed. If you believe the investment is worthwhile, you'll have to outperform the cost of money borrowed and also be able to manage the risks introduced by the added leverage. Leverage can be a double-edged sword. If you are correct with your selection you are rewarded graciously, however if you are incorrect, you are punished equally.
Stock selection strategies vary from adviser to adviser. Valuation methods differ, technical analyses vary, sector leaders change, PE and PEG ratios factor in-you name it. The nice thing about stocks is you can be wrong in the short term, yet with time, a stock worth owning proves its value.
Standardized options effectively represent 100 shares of the underlying stock. This basically indicates that you have increased your leverage. An increase in leverage-without the necessary skills to manage the increased leverage-can create undesirable situations in an investment portfolio.
Options also expire. The same valuation methods that work in selecting a stock won't necessarily carry over to the option selection, because if you are wrong in the short term, you can lose all of the money used to purchase the option if it expires worthless. An option contract used to replace a stock purchase will speed up the loss of money, especially if you are speculating with an unproven method.
Using Options to Manage Risk
How then can an option be used to manage risk? Many books have been written on the effective uses for options. Because this article is quite short, I will try to be concise and point you in the right direction.
A 2009 white paper released by the Options Industry Council, Loosening Your Collar: Alternative Implementations of QQQ Collars, by Ed Szado and Thomas Schneeweis, shows the results of a 10-year study by the Center for International Securities and Derivatives Markets at the University of Massachusetts. The study found that a long protective collar strategy using six-month put purchases and consecutive one-month call writes earned superior returns to a simple buy-and-hold strategy and reduced risk by almost 65 percent.
A "collar" is a strategy in which you own the underlying stock or index. You own a put and you sell a call (one option contract for every 100 shares). The collar strategy allows you to participate in the upside, to a certain extent, and effectively reduces downside risk. Many variations and uses exist for this type of strategy. You should draw your own conclusions from the Szado and Schneeweis white paper, however, this strategy can prove powerful in allowing an adviser and client to discuss ways to manage downside risk but still have the potential for a gain in the market.
Many investment policy statements help determine investment suitability for a client. Assuming risk and reward are on an equal sliding scale (one unit of risk equals one unit of potential reward), advisers map out an investment approach that best fits the investor. Is the client looking for 5 percent annual returns, or 10 percent? A collar strategy allows you to frame an expected outcome for the client and also allow the flexibility for adjustment with a change in the market environment.
Here is an example of a collar strategy:
In this particular collar, XYZ is trading at 129.32. The September XYZ 134.00 call was sold, and the September XYZ 124.00 put was purchased. (The risk/reward is skewed due to the short-term put volatility; see the white paper for details about how to adjust skews.) You have a defined upside and downside, and you have the flexibility to adjust your exposure as necessary or as client/adviser sentiments evolve. You are no longer swimming in an ocean of perceived risk using value at risk models-you are swimming in a pool that deals in absolutes. The water on the deep end doesn't get deeper than where you set it.
Options trading comes with many other nuances, including liquidity risks, pin risks, volatility risks, and tax implications. Advisers and investors should ask many questions and educate themselves on these risks before trading options. If you don't educate yourself on the nuances, you may find yourself saying, "Options are too risky."