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’s a strong case to be made, however, that exchange-listed 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.
The investor is holding an ETF. She believes 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 ETF 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 ETF that is held and that 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 she’s received.
The other risk is that the ETF that’s 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 ETF.
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 ETF 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 ETF price.
Potential To Limit Risk & 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 nonlinear outcomes. They’re 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 the call sold can reduce the total cost, but it cuts off some of the potential profit if prices spike upward.