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More Retail Investors Embrace Options to Hedge Risk

Investors burned by the bad behavior of stocksin the past increasingly are turning to what may seem an odd strategy for calming their nerves — trading stock options.

AP

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.”

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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.

CNBC Investor Spring Cleaning - See Complete Coverage
CNBC Investor Spring Cleaning - See Complete Coverage

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.

CNBC Investor Spring Cleaning 2011
CNBC Investor Spring Cleaning 2011

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.

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“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.”