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Why Do Clients Fail to Understand Option Investments?

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Why Do Clients Fail to Understand Option Investments?

Written by: Michel Barakat

Options have favorable use cases

Options are popular among investments bankers, hedge fund managers and professional traders. They can be used to provide income on existing positions, protection against sudden market drops, higher leverage on the upside, and exposure to almighty volatility. Options can also be combined to create an investment strategy with a customized payoff which is not possible using stocks.

Despite the favorable use cases, many retail investors are averse to holding them in their portfolios, prefering to stick to so-called “less risky” delta one products (stocks, ETFs, mutual funds). I would argue that options are not comparable to stocks and as such are not necessarily riskier. They belong to a separate category of securities (derivatives) with properties which serve a different purpose. For example, stocks cannot be easily used by an airline to hedge against increasing oil prices or used by a farmer to protect himself from a volatile crop market. That’s where options become relevant. When used properly, they can be of great benefit to retail investors too.

But understanding the associated risks is difficult

Risk management is nowadays increasingly complicated. Banks have dedicated teams of risk analysts who constantly evaluate the institutions’ balance sheet, to make sure it can withstand violent market swings. That is not an easy task. The analysts need to keep up with changing regulatory requirements, exotic securities pricing very few people understand, and abrupt swings in rapid markets. Remember the volatility episode in early February? The Cboe Volatility Index (VIX) increased with 177% in a matter of days, led by a global equities sell-off which wiped out close to 10% of the Dow Jones Industrial Average.

Interest rate risk, counterparty risk, liquidity risk and operational risk, are all associated with trading options. Although I have spent a decade market-making equity derivatives on trading floors, I am still puzzled when navigating the risk management maze. You can’t blame your clients for feeling the same way. Options are after all complicated investment instruments and to understand them fully requires knowledge of statistics and quantitative modelling.

You could reframe options to engage your clients

Options may be useful for your clients, but how do you get them excited about using them for investing? They could learn more about them. There are dozens of good options books on the market. An alternative is attending a course about trading equity derivatives. These are all excellent resources for understanding option contracts, risk management figures and the markets they trade on. Fascinating, isn’t it? Or not. The sad truth is that your clients don’t care much about calls, puts, strike prices, delta hedging and expiries.

Using visualisation to present the investment outcome

Investment outcome. That is what your clients are looking for. How much money can I earn If I buy the investment product? What loss will I have to sustain if the investment thesis fails? These questions are simple enough to grasp, yet surprisingly difficult to clearly answer. Retail investors fail to understand options and the associated investment risks because they fail to realize the investment outcome in a simple and easy way.

The answer to our conundrum is to reframe the discussion from the intricacies of trading options and focus instead on the target investment outcome your client wants. Concretely, this issue can be addressed by presenting the investment outcome of an options strategy in an engaging visual manner simple enough to navigate and understand.

Let’s look at an example

Your client approaches you with the following investment thesis about Microsoft. He thinks that within the next three months, the stock might increase up to $105. If the company fails to hit its targets, he expects the stock might temporarily drop but not below $85. We visualize the clients’ target investment outcome below.

This illustration is self-explanatory. The upside is capped at $105 and protection is provided down to $85. Under that threshold, the investment is exposed to the downside. The premium for that strategy is %2.07 of the Microsoft stock price. Under the hood, that options strategy is constructed by combining the following exchange-traded securities:

  • Short MSFT July 2018 Call with $105 strike price
  • Long MSFT July 2018 Put with $95 strike price
  • Short MSFT July 2018 Put with $85 strike price
  • Long 100 stock units of MSFT
     

Now, I will let you decide which one of the above, the illustration or the options list, would help you to best explain to your client the target investment outcome and associated risks? I have constructed this investment strategy using the Cboe Vest Technologies options platform. Get in touch in if you want to learn about how you can help your clients reach their target investment outcome.

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