Investors who are interested in ways to both increase their returns and better manage risk should consider the options market. While some people may be intimidated by the perceived complexity of equity options or associate the market primarily with speculation, these assumptions are not accurate. Options strategies run the gamut from simple to incredibly complicated, but the methods used by long-term investors to generate improved returns and manage risk levels are fairly straightforward.
One of the simplest strategies is selling covered calls. This is a great way to earn extra income from a portfolio of long stock positions. The strategy involves selling call options on underlying stocks held in the portfolio. Although selling covered calls can potentially mitigate some of the upside in a portfolio, it is a conservative and reliable way to generate a few extra percentage points of return in a given year. Writing covered calls is probably the best way for long-term stock investors to get acclimated with options.
These derivatives, however, offer investors a world of flexibility and there are a myriad of other strategies that can be effectively implemented in a long-term portfolio. Semi-active traders can use stock options to hedge their positions when the market is volatile or volatility is expected.
For example, an investor may want to hedge his or her position in a particular stock heading into an earnings report where the security could make a big move in either direction. This can be done by purchasing put options which will gain in value if a stock tanks, offsetting the losses in the underlying position
Put options could be bought outright or an investor could purchase a put spread where options at one strike price are sold in order to partially or completely fund the purchase of puts at a different strike price. In addition to buying put options, an investor could also sell covered calls heading into a specific catalyst and collect the premium.
What is nice about these strategies is that they can protect against heavy losses due to a specific event while maintaining the underlying position. In addition to being effective tools for amplifying returns and protecting against sharp adverse moves, options can be terrific for speculative purposes. When buying calls or puts, your risk is limited to the premium paid for the contracts. It is also possible to make many multiples of the original investment if the trade works out favorably.
For this reason, long-term investors should consider using options when taking speculative positions. This risk/reward framework has inherent and unique benefits that can be consistently capitalized on with solid knowledge of options and a disciplined approach. Innovation in the options industry has also significantly increased investors’ flexibility. Many stocks now have weekly options in addition to regular contracts.
Savvy investors can use a combination of different options contracts to capitalize on opportunities generated by volatility, time arbitrage, reversion, trends, and numerous other strategies. In addition to options on individual equities, investors can purchase calls and puts on a myriad of different market indexes such as the S&P500, Russell 2000 or Nasdaq 100, for example.
Due to the fact that purchasing an option contract generally has a lower capital outlay than purchasing the underlying security outright, and risk is capped at the premium paid, options are a good way to increase a portfolio’s overall risk in a straightforward and simple manner. With the stock market off to a very fast start in 2013 and the Dow having recently hit a new all-time high, some investors may want to be able to increase their market exposure using as little capital as possible. This could be done by purchasing call options on an index.
It is important for a new options investor to understand is the unique risks and rewards which are inherent to this market. The risk/reward profile depends on whether option contracts are being purchased or sold, but the main difference between stock and options is that the latter relies on significant leverage. In turn, this leads to greater volatility in the return profile of options. Therefore, a 5% move in the underlying could result in a 50% move in the price of the options.
The bottom line is that today’s options markets offer significant flexibility to all investors. Although some strategies can get complex, such as ratio backspreads, condors, butterflies, etc., many of the most effective methods of profiting, like covered calls, are very straightforward. When it comes to managing risk and generating additional return, the equity options market provides a wealth of opportunity for individual investors willing to put out the time and effort to learn and effectively strategize.
Options trading involves a high degree of risk and is not suitable for all investors. Before any option strategy is implemented, an investor must determine if such strategy is suitable in light of their particular financial circumstances and investment objectives. Such risks may include a total loss of premium and transaction costs.
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