Article / 27 March 2018 at 10:45 GMT

Why use options? A quick review of their benefits ... and risks

Director, Europe / The Options Industry Council (OIC)
United Kingdom
  • Put options can protect underlying equity holdings from adverse price movements
  • Options can help investors boost income from a stock or ETF portfolio
  • Call options let investors into the market at a much lower cost than buying stocks
  • Stock holders on record at the ex-dividend date receive income such as dividends
  • But call option buyers are not eligible for dividends


By Gary Delany


We often take for granted the reasons we use various tools in our portfolios. In this short article we revisit some of the reasons why options may be appropriate tools for an investor to consider using, which can be summarised as:

  • Portfolio and market risk mitigation
  • Income generation
  • Stock substitution
  • Harness leverage
  • Participate in the market with limited risk
  • Customise strategies with target outcomes
Risk mitigation

Risk mitigation is a key consideration in an investor’s portfolio. By purchasing a put option, an investor can protect his underlying equity holding from adverse price movements. The cost of this is the option premium paid by the buyer of the option. Bear in mind that options have an expiration date, so the investor may have to roll her option position forward, or alternatively purchase another put when the previous one has expired.

The cost of the option can be adjusted by buying more or less price protection. An at-the-money option (that is, with exercise/ strike price at the market price of the underlying equity) will normally be more expensive than an out-of-the money option (that is, with an exercise price below that of the market price of the underlying asset).

chart
 Source: The author


Income generation

Options can help the investor to increase his income from his stock or exchange-traded fund (ETF) portfolio. There are two ways to approach this: the covered call and the buy-write.

For the covered call, the investor is already holding stock and believes that its price will remain steady, or rise slightly. He or she writes a call against the stock he is holding. The strike price of the call sold dictates the limit to which he will benefit on the upside.


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Options as building blocks for advanced strategies ... the range of strategies that can be built using options and underlying equities is practically infinite. Photo: Shutterstock.


In the example shown below, the investor has sold a 55 call. If the underlying price rises beyond 55, then the option he has sold can be exercised by the counterparty, and the underlying stock purchased. The call seller has still received the premium for writing the option.

If the underlying price stays below 55, then the stock holder will receive the premium and also continue to own the underlying stock. If the price falls, then the call option sold will not be exercised and the premium received will offset, either wholly or partially, the fall in the stock’s price.

chart
 Source: The author

The buy-write is similar to the covered call, but the purchase of the stock or ETF and the sale of the call option are done at the same time. The investor in this case is hoping for the call sold to be exercised, thus securing the maximum return on the strategy, and then to repeat the exercise with another stock.  

Stock substitution

Buying stock outright involves paying for it. Using a call option instead allows the investor to participate in the market at a much lower cost in the near term, as well as the long term with LEAPS®.

Remember, however, that an option has a limited life span and then expires. Remember also that stock holders on record prior to the ex-dividend date are eligible for other income such as dividends, but call option buyers are not.

Not all underlying stocks or ETFs have an option available on them, in which case some investors may seek to match an underlying stock with an option on a similar stock, which they believe to offer a reasonable fit.

Harness leverage

In general, call option buyers do not receive dividends or other cash distributions, unlike stock holders. But they do gain the benefit of leverage if their option view on the market is correct.

If an investor buys a call option and the underlying equity rises beyond the exercise price (or in the case of a put option purchaser, falls below the exercise price), then she will benefit from leverage.

chart
Source: The author

The table above contrasts different outcomes for a stock holder and a call buyer. If the underlying equity moves up in price, then the call buyer receives a higher percentage return on the money she has invested in buying the call than if she had bought the stock or ETF outright.

The downside for the investor is that if the anticipated up-move does not happen, her investment will be reduced, possibly to zero. The underlying stock or ETF holder enjoys a lower percentage return for a rise in the price of the underlying equity, but she also experiences a lower loss as expressed as a percentage of her original investment if the underlying moves down.

Also, holding a stock or ETF does not have a time limit, and dividends for stock holders on record prior to the ex-dividend date will still be received regardless of the price, if the underlying pays a dividend.

Invest with limited risk

Buying calls or puts allows investors to position themselves for an anticipated market move by paying the option’s premium to the option’s seller. The most that they can lose is the premium, which could still be all their investment funds.

chart Source: The author

The experience of option buyers contrasts with the case for the sellers of calls and puts. Again, option sellers will have their own directional view on the market. In the case of the put seller, she will hope that prices will rise so that she can keep the premium at expiration and perhaps sell another put to generate more income or buy the underlying in the case of an exercised put.

In the case of the call seller, he will hope that the prices will remain flat below the call strike price. If the market does not move as anticipated, then the option will be exercised and the call seller will be obliged to sell the underlying in the case of an exercised call.. This will involve a cash outlay that may be considerable, only partly offset by the premium received. 

chart
 Source: The author

Custom strategies, targeted outcomes

Finally, options can be used as building blocks for more advanced strategies, that will give specific anticipated outcomes at different price levels. The range of strategies that can be constructed using a mixture of options and underlying equities is practically infinite.

In a short article like this we will limit the focus to the example of the Protective Collar. We have already discuss the covered call (the investor is holding the underlying equity and sells a call against it). The collar builds on this by adding a long call option underneath the current market price of the underlying equity, which is partly financed by the call option that has been sold.

The net effect of the combined position can be seen below. The out-of-the-money put option purchased gives protection on the downside. The profit potential on the upside is limited by the strike price of the call option sold. The strategy can be made more or less expensive by adjusting the strike prices that the call option is sold at and the put option bought at.

chart
  Source: The author

In conclusion, options are versatile tools that can be used by investors in a variety of ways, including: risk mitigation, income generation, stock substitution, as a means to harness leverage, participating in the market with limited risk and finally, being used in conjunction with other options or underlying positions to create targeted outcomes. Nevertheless options are not without risk and are not suitable for all investors.

Saxo Bank’s educational initiatives can be found here

– Edited by Robert Ryan

Gary Delany is European director of the Options Industry Council.

 
Disclaimer: Options involve risk and are not suitable for all investors. Individuals should not enter into Options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org.
In order to simplify the computations used in the examples in these materials, commissions, fees, margin interest and taxes have not been included. These costs will impact the outcome of any stock and options transactions and must be considered prior to entering into any transactions. None of the information in this post should be construed as a recommendation to buy or sell a security or to provide investment advice. ©2018 The Options Industry Council. All rights reserved.
FURTHER CONTENT
More content in the form of online classes, videos and webinars is available at the OIC website, www.OptionsEducation.org. All information is provided by OIC free of charge.

The Options Industry Council (OIC) and Saxo Bank 
The Options Industry Council (OIC) and Saxo Bank have both invested heavily in their online education initiatives, which enable investors to increase their option knowledge and skills using easily accessible and easily digested content. For OIC’s comprehensive website go to www.OptionsEducation.org and follow us:

See The Options Industry Council on Facebook here
Saxo Bank’s educational material can be found at https://www.home.saxo/education

About The Options Industry Council (OIC)   
Celebrating its 25th anniversary, OIC is an industry resource funded and managed by OCC, the world’s largest equity derivatives clearing organization. Its mission is to provide free and unbiased education to investors and financial advisors about the benefits and risks of exchange-listed equity options. OIC offers education which includes webinars, podcasts, videos, seminars, self-directed online courses, mobile tools, and live help. OIC's Roundtable is the independent governing body of the Council and is comprised of representatives from the exchanges, member brokerage firms and OCC. For more information on the educational services OIC provides for investors, visit www.OptionsEducation.org.
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