Coffee With Cott is a blog from The Options Industry Council's Financial Advisor Division. Eric Cott, the author, is a former advisor who has been the Director of Financial Advisor Education at the OIC since he developed the organization's outreach program in 2009. Coffee With Cott offers percolating insight on options strategies, as well as practice management ideas.
Options are applicable and can provide solutions to many situations encountered by financial advisors and their clients - they always make for interesting conversations and can be great for developing investing ideas. But there are certain days when it can be an even more apt time to elevate the topic and tackle the details.
With this being the 100th year of pro football - and also the 46th for The Options Clearing Corp. and the 27th for OIC - I've decided to cover one of the most important reasons to consider options in your clients' investing plans. That's playing defense. While options are also used for offense on a regular basis, for this blog post, we'll concentrate on the defensive side.
If you're a sports fan, even in passing, you've heard the phrase "defense wins championships" countless times. Now, that may be up for debate on the field, but when it comes to your clients' portfolios, it's an adage worth considering. That's because the utility of options as a hedge or to express a bearish view can be one of the main benefits of these assets, for large and small accounts alike.
Here's something else to know. When you've got a defensive-minded client, options can provide alternatives that may be effective without being overly complex. So, let's get this tailgate started (in this arena, I'll recommend java as the beverage of choice for this discussion).
Before a client can implement any type of defensive action, options must be understood. It's essential to know the playbook well, namely the benefits, the risks and the ability for advisors and clients alike to stay grounded. The good news is that you don't have to get overly complicated with options to develop a good defense. You simply need the right pads, helmets and schemes. Let's begin with two popular strategies that can be used for market risk protection.
Protective put: Here's the scenario: Your client has a stock or ETF that's profitable, but they're worried a decline may come along and diminish their gains. While there's more than one way to mitigate downside risk, one idea is for the client to buy a protective put. When an investor buys a protective put, they're choosing the price (strike price) at which they would sell their stock or ETF.
Purchasing a put gives your client the right to sell their underlying holding at the strike price - should they decide to exercise their right to sell. Although buying a protective put on its own requires a cash outlay, it offers a cushion if a drop does in fact occur. Alternatively, your client could implement a put spread, which we mention later in this blog post, to offset some of the cost. Protective puts are often described similarly to insurance on your house. See our protective put video for more details.
Collar: The collar is a two-legged strategy - a bit like a flea flicker in football that involves both a handoff and a pass on the same play. Because it's a combination of a protective put with a covered call, the collar limits participation in the underlying's gains, but it also provides a downside buffer. A covered call is a strategy when a client sells a call against a stock or ETF they already own. With a collar, the income from the call sale offsets part or even all of the cost of buying the put. Note that a collar can also be used with an index as the underlying instrument.
Because of the covered call part of the collar, this strategy establishes a maximum price where clients have to be ready to give up their underlying stock or ETF at the call strike price, which is what happens if they are assigned. Meanwhile, the protective put component simultaneously sets the floor to sell the underlying at the put strike price. Watch our video on collars to learn even more.
What if your clients don't want a regular cup of joe? They're thinking it might be one of those double-espresso, vanilla-hazelnut kinds of days. If they want a strategy that may be a bit on the bolder side, they can do that with options, too. Here are a couple of possibilities.
Put Spread Collar: A put spread collar has the same structure as a traditional collar, but with one additional component - which is to sell (short) an out-of-the-money put. With this defensive strategy, your client would sell a call and buy a bear put spread.
The put spread collar, which is usually done for risk management, was described in a recent study sponsored by OIC. The study focused on endowments that were using the strategy, but the put spread collar was found to enhance risk-adjusted performance in that context.
Long Ratio Put Spread: When you have a client who's bearish about a stock or ETF, this is one possible way to show it. With a long ratio put spread, your client would sell one put and buy two more puts that have a lower strike price, with the expectation of profiting from either a pullback in the stock or ETF, or from a big increase in implied volatility. (In summary, implied volatility represents the market's view of the range in which a stock or ETF will be trading in the future. It's another important aspect about options that advisors and clients need to understand.)
The long ratio put spread is a long put that's been combined with a bull put spread. A 1 x 2 spread like this isn't a "Hail Mary" pass - it just requires more planning between advisors and clients.
All Four Quarters
In conclusion, we're off to a great start in describing the defensive capabilities of options, but we're really just getting the lights turned on. You can find out even more about how options can be used for defense in our video, Playing Defense With Options, featuring my OIC colleague Joe Burgoyne.
While football is made up of clear winners and losers (ties notwithstanding), the options market is a place for buyers and sellers. Your client could be either or even both at the same time. For you, the advisor, this is where you can help map out a game plan by determining if your client is bullish or bearish. If they're bearish, option strategies can be a front-line defense for certain market situations. Either way, it's prudent to be your clients' coach so that you can offer potential solutions for any type of market.
As always, if you've got any questions about options, email me directly at email@example.com or the industry professionals I work with in Investor Services at firstname.lastname@example.org. Finally, a note to advisors about my upcoming schedule: I'm going to be in Washington, D.C., at a conference Sept. 9-11, and then I'll be in Philadelphia for another event Sept. 18-19. If you will be in either city while I'm there, let me know. We can plan on getting a coffee and talking about whether options, defensive or otherwise, might make sense for your clients.
For more information on how OIC works with advisors, visit the advisor portal on our website. Do you have a topic you want to see covered in the Coffee with Cott blog? Let us know by writing to email@example.com. We want to hear from advisors like you with all your questions on options.
Options involve risks and are not suitable for everyone. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, available by visiting OptionsEducation.org or by contacting your broker, any exchange on which options are traded, or The Options Clearing Corporation at 125 S. Franklin St., #1200, Chicago, IL 60606.
In order to simplify the calculations 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. Investors should consult their tax advisor about any potential tax consequences.
Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and should not be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.
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