The reputation of options as high-risk speculative side bets persists even as the market expands and its utility becomes more mainstream. But in fact, options can be speculative and high-risk or very conservative and used to manage risk in a long position portfolio.
The idea of options as risk management tools should not be surprising; in fact, more traders and investors are using conservative strategies to reduce risk and augment portfolio income than ever before. Think about the many combinations and hedges that do just that, and it becomes obvious that options are great ways to manage the portfolio beyond the traditional decisions, limiting you to buy, hold or sell.
For example, a stock in your portfolio recently leapt to the upside and gained 20%. You think it will retreat at least to a degree. So do you sell? Maybe you really want to keep this company in your portfolio, but at the same time you’re afraid of losing those paper profits. Second, if you do sell, it will be a short-term capital gain and your taxes will take a hit you’re not prepared for. This is where several possibilities come in, including the insurance put to gain downside protection; the deep ITM call (advancing yourself income far above your original basis, so that if the stock price does retreat, you close at a profit; or if the stock price does not retreat you accept exercise, close, or roll forward). These are only the most obvious examples; if you think about it, you can come up with many more conservative options strategies to manage portfolio positions, protect paper profits, and create income.
Looking at the opposite movement: What happens if your stock price declines and now you’re stuck with a paper loss? You expect a rebound, but how long will that take? You need a recovery strategy in this case. It may consist of long calls or even short puts. You reduce your paper loss in either case when the stock price moves up. And if it continues down, your short put discounts your loss and you can close or roll forward. In other words, there is always the possibility of a way out, that you probably do not have just by owning stock.
Options and their perception in the market are gaining a better reputation. They might have been the market bad kid many years ago, but today they have redeemed themselves. As the range and scope of strategies grows and as options expand into many more forms of underlying, more investors will embrace them — gradually perhaps, but eventually even the most ardent old-style buy-and-hold true believer will be ready to take options home to meet the folks.
Michael C. Thomsett