Options and Why They Matter

While it may seem obvious why options are a valuable and necessary components to any well planned portfolio, few Investors and Investment Advisors make use of options in their overall portfolio strategies.

It’s unclear exactly why this is the case, maybe a lack of understanding or confidence in the product is keeping the vast majority of investors from employing these very valuable derivatives. Also there are dozens (hundreds depending on who you ask) option investment strategies, in general there are three basic ways to use options to augment an existing investment portfolio which for our discussion we will refer to as defensively, offensively, and yield-enhancement.

Defensively

Buying Put options are generally your best bet in defending a conventional “buy and hold”, static portfolio. Put options are derivatives that allow the holder of the option to Sell at a predetermined strike price. For example, if you owned 1000 shares of Royal Bank (RY) shares at $80/share and bought a Put option with a strike of $75, if RY drops anywhere below $75 you have the right to sell at the strike price. This is obviously a very powerful tool as this affords the buyer of the Put option certainty that they can’t do any worse than $75 on their shares. The draw back on this is the cost of the option which can be related to buying insurance on your car. It’s a cost of the protection that you hope you never have to use.

Offensively

Buying Call Options is another way to Bullish a company but with far less upfront capital required. For example, if you are bullish MTS Allstream (MBT) which is currently trading at $25 and think it’s going to trade above $27 within say three months, you can buy Call options which gives you the right to buy the shares at a predetermined strike price. In this example, the price per share in the Call Option is trading at $0.20/share for the right to buy MBT at $27 within the next three months. To control 1000 shares, it would cost you $200 (MBT Call Options @ $0.20×100 shares) rather than $25,000 (MBT @ $25/share x1000 shares). If you’re right and say MBT trades to $27.50 after a month, you can exercise your options and net a very nice profit for little upfront risk. Also note, that your full exposure to the downside is the premium you paid for the Call Options, which is only $200. While if you bought the shares outright, you have tied up a significant amount of capital and are exposed to all types of market risks.

Yield Enhancement

While the above defensive and offensive options strategy is only a basic way to use Puts and Calls, the most beautiful thing about Options are the countless number of scenarios which they can be applied to enhance the yield of a static portfolio. One of the most basic and obvious ways to enhance the performance of a static portfolio with little to no additional risk to the portfolio is the use of Covered Call writing. While this requires some active management, a professionally trained Investment Advisor should be able to help investors apply this strategy with relative ease. So brass tax… what type of potential yield enhancement are we talking about for this relatively basic Covered writing strategy? The answer is between 6 to 18% in additional to the current yield you’re receiving.

Options are powerful derivatives that should be employed in some fashion for every professional managed portfolio. Too many investors are leaving too much on the table without even considering the power of options. Contact a professionally trained and licensed investment advisor today to learn more about how options can help you achieve the results you’re looking for in your portfolio!