With puts and calls, forget sexy. Go for functionality. It’s not so boring, after all.
Using put and call options in portfolios is one of the more popular topics with investors. Yet I find that different groups of investors approach it differently. Do-it-yourself types often get lured in by the levered effect that options have, and the salespeople, I mean, options “gurus” that promote them.
Financial professionals I coach on the use of options for their clients tend to be a very attentive audience, and typically learn it the right way. It is all part of being a fiduciary to your investor clients.
Then, there is my direct investment work. That typically consists of buying put and call options as a surrogate for making a larger investment in some market segment or the market as a whole.
Option basics: a super-fast review
Obviously, there are more ways to use options, and more combinations than I can list here. But as a quick review, the “variables” in any option position starts with these:
Expiration date (when the option contract ends)
Strike price (the price at which the option allows you to buy or sell a security)
Position size (how many contracts you buy or sell, and how many shares of the security that translates to)
“Moneyness” (how close the market price of the security is to the strike price of your option)
Be educated, not sold to
Many investors are quick to be confused by options. I think that has a lot to do with how some people “sell” them to the investor. And frankly, I don’t like that.
Options are not that different. They just have a limited time, and may not reflect market conditions as they are today.
There is plenty of strategy to understand about using options to add value and/or protect your portfolio. It takes some effort. But if you harness that, you have yourself a very helpful tool to add to your investing arsenal.
This was never more true than earlier this year. Options are at the greatest potential benefit if you buy them when volatility is low, and the market is calm and unsuspecting. That is, provided those conditions change. You can spend a lot of money on options, waiting for something to happen. But the time slips away, and takes your assets with it.
2019 and 2020: A master class in the pros and cons of options
As it turns out, the last quarter of 2019 and the first quarter of this year were an excellent time to have understood how options work, and how to use them prudently. A 4-month rally started in October of last year, and it saw the S&P 500 rally by over 15%. That was a good time to own “out of the money call options.”
Of course, the 5-week period that ran from February 19 to March 23 of this year was a great time to own put options, especially if you owned them before the junk hit the fan, so to speak. You had that opportunity to buy when volatility was low, and sell when it was historically high.
I cannot possibly cover the many angles involved in using options within the broader portfolio context in this article. But I can deliver some bottom-line conclusions.
Some of these are direct result of my using options more in the first several months of 2020 than I ever have in my career. My portfolio team and I went back and analyzed our performance from the first half of the year. Here is what we already knew, but which is now cemented in our brains as a result of the experience:
Options should be a limited percentage of your portfolio
For the type of straightforward buying and selling of options I practice, allocating more than 10% of one’s total portfolio at one time is courting more risk than most can handle. My typical range is 2-4%. That said, the more cash and non-volatile assets you own, the more you can use options as a surrogate for both long and short stock and bond market exposure. And, that small amount of options can still give you plenty of “notional exposure” to the market areas you want.
The best part about buying options is…
They allow you to define your worst-case scenario. If you buy an option and it costs you $1,000, that’s all you can lose. Where folks get into trouble is when they speculate using options, and introduce risks they don’t understand. Or, they do understand, then have buyer’s remorse when things go wrong.
Options are an enhancement to a portfolio, not the main attraction
A lot of my portfolio’s success this year is due to the boost one gets from owning put options during the fastest bear market in modern history. However, it can also be a double-edged sword.
A market plunge drives up volatility, and while you can sell put options for significant profit, any put or call option you buy at that point is going to cost a lot more, pound-for-pound. So the best of times for options can sometimes be fleeting.
As it is. Volatility is still very high. As measured by the VIX Index, it is around 26. Shortly before the recent market decline, it was 12. It peaked in March at over 85!
Bottom-line: I am using options more sparingly, and in a more targeted manner than earlier this year. Note that I did not discuss “selling covered calls” and other strategies where one sells an option to bring in cash, in exchange for an obligation to sell or buy a security if it hits a certain price within a specified time period. Most option-based ETFs and mutual funds are driven by this pursuit of “income.” I certainly see the attraction, but I also see a lot of risks that only become apparent when markets get disruptive. So, buyer (or more correctly, seller) beware there.
How to use options without using options
As I noted, there are several ETFs and mutual funds that use options in part to drive their targeted outcome. Some are good surrogates for doing the option work yourself. Others are gimmicky. And some are in between.
Finally, understand that using options is very fluid. I have used them for decades, but never less than a few years ago (low volatility markets are not friendly to my options investing style). I never used them more than I did earlier this year. And currently, they are simply a garnish in some of our portfolios.
The key for you: learn how options work, and not through a sexy sales presentation. Then, determine what type of option approach appeals to you. Based on that, make a decision about how much of that option work you want to do yourself, and how much you want to farm out to ETFs, mutual funds or other vehicles you may research.
Substance over form
Options can play a very straightforward role in your portfolio. You just have to separate yourself from the hype and “glory” of options as portrayed in many corners of the financial industry. After all, investing is about pursuing your specific lifestyle objectives. It is not a sport. Don’t risk going down in a blaze of glory.