More Retail Investors Embrace Options to Hedge Risk
Special to CNBC.com
If, say, an investor owns 100 shares of 3M , which was bought at $90 a share. To write a covered call, he could sell a $100 call on 3M shares for $5 a share, that expires in two months. Option contracts are typically for 100 shares, so the investor would get $500 for selling the contract. If in two months, the shares don’t hit $100, the option expires worthless and the investor keeps the $500 premium.
An investor entering into a covered call strategy would also have to expect that his or her shares could be “called” away if 3M hits $100 a share on or before the expiration date. As a result, the strategy is best for stocks that don’t have dramatic price movements, says Kinahan at TD Ameritrade.
This strategy can also be used to issue a call on the entire S&P 500 index through a Chicago Board Options Exchange product called the CBOE S&P 500 BuyWrite Index or BXM. The BXM “in a passive repeatable way,” is a covered call on the S&P 500, explains Guziec.
The index buys the S&P 500, issues one-month call options on the entire index, and does this month in and month out, delivering a return comparable to the index but with a lot less volatility, Guziec says.
“People tend to panic when things drop suddenly, and this is a product that seems to mute that effect,” Guziec says.
Why buy options?
Other than hedging risk, options allow investors to make bets without risking as much capital as with an individual stock, according to Kinahan at TD Ameritrade. If, say, investors expect IBM to rise, they could buy calls on IBM stock for a fraction of the cost of buying IBM shares.
“The nice thing about options is you can define your risk, which isn’t always possible when you buy individual stocks,” he says.
Options can be useful for active traders who don’t want to bail out of the market and move into cash when markets seem rocky. “They want to hold positions, but put on protections so they don’t lose out,” says Frederick at Schwab.
Scudillo as EisnerAmper worries that many options have a limited time frame, which means investors are continually exposed. “You need to make it a full time occupation to really master it, and you’re timing the market,” Scudillo says.
And in the case of a conservative strategy, like covered calls, investors can miss some of the market’s upside.
“That ties back to standard investment philosophy: If you are capped on the upside of some of the market’s best days, that could significantly hamper your returns,” Scudillo said. “You need those highs of the market to ride out the downturns.”
But as Frederick at Schwab says, many investors are more interested in options now than ever before, even as stocks continue to rise, because they don’t want to lose money. Typically interest in limiting risk through options wanes in the midst of a bull market. But with global and domestic events creating almost daily uncertainty, Frederick only sees interest accelerating.
“We are two years from [the market bottom)] and I haven’t seen a slowdown," he says. “I don’t think people are quite as comfortable this time.”