More Retail Investors Embrace Options to Hedge Risk
Special to CNBC.com
After all, options aren’t exactly simple, and with names like “collars” and “condors” seem to be better suited to big institutions than mom-and pop-investors.
But retail investors are looking at options as a way to hedge risk, smooth volatile returns and squelch worries about losing their life savings.
First a word of caution: Investors need to know that options — a derivative of an actual stock — can still lead to big losses. In fact, some financial advisers steer their clients far away from these complex securities.
“To dabble in options is something we highly discourage,” says Marc Scudillo, managing officer at EisnerAmper Wealth Management. “You need to have a baseline in place, and a prudent game plan in place, through diversification first, before you get involved in these enhanced strategies. People often forget the basics, and go off to these hot trends.”
Many brokerages also agree investors should use options as a way to enhance, or hedge, a core portfolio representing 50 percent or more of their investments, depending on their age and investment goals.
And to avoid investors getting involved in something they don’t understand, brokerages have put a lot of resources into educating investors so they use options correctly — to complement and supplement their core investment portfolio.
“I’m a huge, huge proponent of education,” says Randy Frederick, head of trading and derivatives at Charles Schwab. “You should never trade a product, a market or strategy that you don’t fully understand.”
Used correctly, options can limit risk, and that’s much of the reason for their popularity. The drop in the markets in late 2007 through 2009 scared a lot of investors who began to seek out education on options to avoid another unexpected downdraft, says J.J. Kinahan, chief derivatives strategist at TD Ameritrade, a retail brokerage.
“After watching their 401(k)s get cut in half, they realized ‘I need to do this or I won’t have anything to retire on,’” Kinahan says.
That options trading is a big business for brokerages was made evident on March 22 when Schwabannounced it was buying online brokerage OptionsXpressfor about $1 billion. With the purchase, Schwab gains access to 385,000 accounts with assets of $8.1 billion. As of the end of January, Schwab’s 7.7 million active brokerage accounts had more than $1.4 trillion in assets.
Two years ago TD Ameritrade did much the same thing when it bought thinkorswim Group, an options specialist, for about $606 million.
How Options Work
A stock option is a contract to buy or sell a stock at a specific “strike” price by a specified date.
There are basically two types: A call gives an investor the right to buy a stock, while a put gives an investor the right to sell one.
Philip Guziec at Morningstar views options as a type of insurance for investors who worry about the future.
“Insurance products create value by removing the risk,” Guziec says. “It’s worth it to you because the cost of the uncertainty, of the sudden loss in the value of your car or house is worth more to you than the cash payment for the insurance,” he says. “Options in a theoretical sense have the ability to do that: those who value risk more exchange with those who value certain cash flows more.”
Less Risk, Less Cash
An increasingly popular product used by investors who want to potentially earn extra income on a stock they already own is a covered call. This is when an investor sells a call on a stock that he or she owns.