Fighting risk with risk: How options can protect portfolios

If you're in the investing game for a big score, options are one of the high-stakes tables. Like all derivatives of other assets, they are naturally leveraged. You can win big and you can lose big.

Options, however, are also a powerful tool for hedging the risk of an investment portfolio. If you're worried about surging stock indices but unwilling to unload your investments, an option to sell the S&P 500 Index — or a huge range of other, more specific segments of the stock and bond markets — can cover some or all of your risk.

"If the market sells off, the value of the put option rises," said Brett Carson, director of research at registered investment advisor Carson Wealth Management. "We're not trying to time the market, but we use put options on the S&P 500 to reduce risk."

Traders in the Standard & Poor's 500 stock index options pit at the Chicago Board Options Exchange.
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Traders in the Standard & Poor's 500 stock index options pit at the Chicago Board Options Exchange.

Carson's firm manages more than 15 different investment strategies based on the risk tolerances and income goals of its clients, but for a client's "irreplaceable capital," protection is the key, and options are a good tool to achieve it.

"For the sleep-at-night money that clients are very protective of, the foremost goal is to manage the downside risk," Carson said.

He sees three major ways to do that: Look for undervalued companies with good balance sheets and strong fundamentals that are likely to hold up better in a market selloff; use technical analysis to identify sell signals in the market; or buy put options on the S&P 500 Index to offset big losses in the market.

"The idea is to limit the downside to 10 percent," he said.

It will cost you. The cost (or premium) to buy options — whether puts or calls — is significant, particularly in volatile markets. On July 20 a put option on the S&P 500 with a strike price of $2,175, expiring at the end of July, cost $13.28. The larger SPX contract, typically used by institutional investors, covers a notional value 100 times the index, or $217,500, and costs $1,328. The smaller mini-SPX contract covers one-tenth of that amount, for $132.80. The more volatile the market, the more expensive the options will be.

"It gets very expensive to buy rolling put options," said Barry Glassman, founder and president of Glassman Wealth Services. "It can work, but if a client is really worried about risk, we reallocate their portfolios rather than buy options."

"Anyone who has bought put options because they believed the market had hit highs and would drop has mostly lost." -Barry Glassman, founder and president of Glassman Wealth Services

Peter Mallouk, president of Creative Planning, also sees the cost of options as prohibitively expensive. If he sees significant risk in an investment, Mallouk prefers to simply diversify into other asset classes.

"Options are insurance that dilute returns over time," he said. "They protect against downside risk, but you pay a price.

"We prefer to determine what markets we want to be in and accept the volatility that may occur."

If you lack the time and inclination to actively manage your investments, however, options can be a quick fix for investors who feel vulnerable. Depending on how you use them, you can customize the amount of risk you assume and target ranges of return to pursue.

There are two sides to an options contract: the buyer who purchases the right to exercise the contract, and the seller (writer) who is obligated to fulfill it.

Options primer

A put option carries the right to sell an asset at a strike price for a specified amount of time. If the asset price falls, the option buyer can either exercise the contract to sell at the higher price, or more often sell the option in the market.

If the market rises above the option strike price, it expires worthless, but the investor is protected from the downside risk of the underlying assets.

"Anyone who has bought put options because they believed the market had hit highs and would drop has mostly lost," Glassman said.

A call option gives the buyer the right to buy the assets at a price up to a specific date. It's a bullish bet and protection against missing a strong move up in the market. If the market is flat or down, a call will expire worthless and the investor will lose the premium they paid for it. If it rises above the strike price, the investor can buy the assets at the lower price.

The flip side of buying options is selling them to others (or writing options). Be very careful writing options.

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Selling a put option on assets at or near the market price is a very risky bet. Unless you are a devoted market timer and sure that the market will continue to rise, selling put options can crush you. The premium you'll receive may be attractive, but the theoretical downside is limitless.

The same is true of call options. The writers of the option receive the premium from the buyer and assume the risk of a rising market. If they don't own the underlying assets, they could be forced to buy them at the higher market price to fulfill the contract.

Writing call options on assets that you own, however, provides a measure of protection for a portfolio. It won't cover you to the degree that buying a put option will, but the premium you receive can offset declines in the value of the assets.

What's more, you can still participate in market upside if you write the option at a strike price above the market. For example, if you write a call option at 5 percent above the market, you give up any move greater than 5 percent, but you also pocket the premium.

Carson Wealth Management uses covered call-writing strategies on individual stocks as a means of generating income — attractive in a low-interest-rate environment. He uses high-quality dividend-paying stocks to minimize downside risk and typically writes them just slightly out of the money (near the market price).

"We can increase our income from those stocks by two or three times and provide some cushion to the downside," Carson said.

— By Andrew Osterland, special to CNBC.com