Retiring: Got Options?
People approaching retirement or who are already retired have gotten used to an investment routine. A while back, they decided on a mix of stock index funds and bond funds. These may have been provided by their employer’s 401(k) plan. Alternatively, a business owner may have built his or her wealth through a self-driven or professionally-advised portfolio management process. Since 2009, it has been a nice run, generally speaking.
Today, however, headlines about recession, bear markets in stocks and interest rates heading toward zero are making this existing approach look more like a fairy tale. What worked in the past may not work in the future.
“But, its been working”
But who wants to change what has been working, while they were working? The investment climate post-financial crisis has created a level of comfort for investors I can only liken to when I get home from work, and see my 2 cats lying around. Unlike Rose and Joey, this may be a good time for you to get up and move around when it comes to how you invest for retirement.
The conditions are changing, yes. But so too have the weapons you have available to fine-tune your retirement investing approach. In the years I have been communicating with investors, either 1:1 or in groups, perhaps the most common question I get has to do with using options alongside stocks, bonds, ETFs and mutual funds. Thus, it seems like a good time to present a quick overview of how one professional investor (me) uses options as part of a portfolio.
There is a wealth of information on the basics of options. I am going to explain to you what I see as the motivation for considering certain types of options strategies: specifically, buying puts or calls with the aim of accomplishing very specific outcomes. And, doing so as a complement to your main portfolio, not as a portfolio all by itself. With retirement threatening to destroy wealth in a way you did not need to consider the past 10 years, this seems like a good time to share that with you.
Meat and potatoes
I refer to my approach to options as a “meat and potatoes” use of them. That is, I take a very straightforward view of how and when to use them, and why. You will not hear me talk about delta, gamma and vega (unless its the great Suzanne Vega, the outstanding singer from the 1980s). Options can get very geeky very quickly.
I am also not going to talk about using options for speculation. There are other investment pros that brag about 1,000% profits and the like. That’s nice for them (though in most cases, unverified). I work in the fiduciary world. Here, we use options as an alternative to investing a full wad of hard-earned dollars in an investment within the portfolio.
Less risk, similar results?
Essentially, I think the best reason to consider options for preservation-oriented investors is simple. It allows you to commit a limited, specific amount of capital to try to achieve what you might otherwise need much more money to accomplish. This also means that when you buy an option, you know you can only lose what you put up. So, you define your worst-case-scenario up front.
Also, I am going to focus here primarily on buying options, in hope of selling them at a higher price. There are all kinds of strategies using options, including some that offer high potential returns…but risk of unlimited loss. That is for someone else to educate you on. My options focus is more on that aspect I mentioned earlier: as a lower-cost surrogate for taking a position in something to help drive your returns and protect capital.
Buying protective puts: “catastrophe insurance”
2008, 1987, and other difficult periods for the stock market taught us that nothing is “safe” in investing. The stock and bond markets now clearly have everyone’s attention. This is typically when folks start clamoring for ways to offset the flogging that any equity portfolio is likely to experience when things get worse. For decades, the purchase of put options on an index, such as the S&P 500, has been one way to do this.
Buy a put option gives you the right to sell a security or index at a specified price. It essentially allows you to set a “pain point” in terms of a market level. There are several additional factors that go into choosing specifically which option or options to use, and when. That goes beyond the limits of this column. For now, suffice it to say that spending a piece of your portfolio assets to draw a line in the sand can be helpful.
Options are now also available on many ETFs. So, if you have heavy exposure to an industry, sector, geographic region or even a stock, protective put options is an area you may wish to learn more about.
Buying call options
While the purchase of a put option can help you put the clamps on your downside risk in a portfolio, buying call options can do the opposite…and maybe more. Buying a call essentially gives you the right to buy a security or index at a specified price.
So, if you think that the value of some market segment will be much higher 6 months from now, you could buy a stock or ETF to participate. But in an environment like this, you also know that the price of anything could be taken down sharply. That’s what volatility brings to your retirement goals: uncertainty.
In a situation like this, the purchase of a call option represents a trade-off: you pay some money now (an “option premium”) for that right to own a security at a price. But there is a chance that if it gets to that price, you would have been better off buying it outright. Thus, the option allows you to be rewarded if it works out, but limits the loss if it does not work out.
The other interesting way to use call options is as a replacement for some of your exposure to an investment. For instance, you could have 60% of your portfolio in stocks. But using options, you could try to achieve the same “exposure” to the stock market by having, say, 40% in stocks, and using call options to replace the other 20%. There is some number-crunching to do in order to determine how to do this type of surrogate investing (options as a surrogate for stocks). But again, this article is primarily about introducing the concept to you.
Exploiting market volatility
There are times when even the most skilled investment professionals have no freaking idea of what the next major move will be in the stock market. Or the bond market. Or commodities, or anything else. Now, investing is not about making market calls. But sometimes, your analysis tells you that the most likely thing to happen is that the market will go up sharply AND down sharply. We went a long time without this happening, but since the start of 2018, it has happened more often.
This is where options may provide a way to simply try to profit from market swings, regardless of which direction they occur in. And, if you position it correctly, you may give yourself a fighting chance of profiting both ways. This is generally referred to as “being long volatility.”
The strategy I have used on several occasions is called a “long combination.” This involves buying a put and a call on the same security. The specific price levels and length of time until expiration of those options may differ. Once again, that’s a concept. The implementation is a couple of steps beyond what we’ll be able to cover here.
I just mentioned that options investing involves a length of time. That is one of the biggest potential drawbacks to using them. If you buy a stock or an ETF, you can hold it as long as you like. You can lose money for years, then eventually profit.
With options, there is a limited life. They have set “expiration dates” like a carton of milk. And, while you can take your chances with expired milk, with options, when that expiration date arrives, everything gets settled up. So, in using options, keep in mind that you can be right but early, and that does not help you. Still, life goes on, and so does the options market. If you believe that you have an eventual profit situation, you can buy an option on the same security that expires later than the one you own. You can also just swap one for the other to keep yourself in position to benefit if the move you anticipate occurs.
There’s a cost to everything…and sometimes it’s too much
Another thing that confounds options investors is when the market gets a bit crazy. That causes volatility to spike higher. Why is that a problem for options? Because options are priced (valued) based in part of the current and anticipated level of volatility in the price of the underlying security.
So, when considering options, it is important to find something that can act as a tool to accomplish what you want, via puts, calls or both. However, you also must factor in how volatile that market area is. The toughest time to buy put options to protect your wealth is when everyone is panicking. That makes the same put option much more expensive than it was recently. So, you have to be conscious about how much you are paying for the protection or enhancement of your portfolio.
To me, buying puts and/or calls to guard against major losses in value, or as a surrogate for putting a bigger amount of money at risk, is an underused part of investing today. It is a role player alongside a portfolio, at a time when most portfolios are sitting ducks for a bear market and recession. Even if that does not occur, I think the stress of contemplating it, and figuring out what to do is not worth it.
There are other ways to invest when you are close to retirement or in retirement. The meat-and-potatoes options strategies I introduced here are one of several tools you can add to your toolbox as the easy times of the past decade get more challenging.
And if most of your money is in a 401(k) plan…
As a keen observer of market behavior and investor behavior since before the 1987 stock market crash, I am concerned. My concern is that some investors risk major losses in the next bear market due to perceived constraints.
However, a large portion of Americans’ retirement wealth is in retirement plans. You probably don’t have the ability to use options in that plan, if you are still obligated to be in the plan. That does not mean you cannot use options outside that plan, but specifically to act as a cushion or enhancement vehicle to where the bulk of your assets must be for now.
Sure, 401(k) plans are like Las Vegas: what happens there, stays there, at least until you are eligible to roll the plan to an IRA. That can typically happen at age 59 1/2, or when you retire, whichever comes first.
But even if you don’t touch your retirement assets, you can still use outside money (in IRA or taxable accounts) to employ these option strategies. Remember, they are a role player, not the central part of the portfolio. However, in the most volatile markets, they can play a leading role, just when you need it most.
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