The months of 2020 have been an eventful period for the financial markets, and that's putting it mildly. We have seen new all-time highs for U.S. stocks, a sizable pullback fueled by worries about the economy amid the global spread of COVID-19, an increase in volatility, a drop in rates, and even impeachment proceedings.
Still, every year experiences its ups and downs and sometimes in significant ways. No one knows with certainty what the next day holds but being prepared for future challenges is sensible and prudent. For some, that may involve learning about new investing ideas, such as how exchange-traded options may have a place in their financial plans.
The Options Industry Council’s (OIC) mission is to increase the awareness, knowledge and responsible use of exchange-listed equity and index options across a global audience of investors - including individuals, financial advisors and institutional managers - by providing independent, unbiased education and practical knowledge. We try to diminish the misconceptions about options, because when they are responsibly implemented into a financial plan, options can have genuine utility within a portfolio.
Options and Versatility
Two central themes with options are managing and mitigating risk. If we take this further, options generally are tools to enhance or potentially add income to a portfolio or to protect against downside risk.
If you are a financial advisor or RIA with a client who is long a stock or an ETF, you may want to consider opening a conversation with your client about positioning options within their portfolio, because with protective strategies, options have the potential to provide an added layer of safety.
Let us consider a hypothetical client who has 100 shares of a stock. The client is concerned about the market and believes there could be some downward movement on the horizon. One strategy solution is the protective put. This strategy is similar to homeowner's insurance. The protective put sets a minimum price at which the client would sell their underlying security, in the event their stock or ETF were to decline in value.
What if a client is interested in generating additional income instead? One strategy that is common, especially for investors and advisors who are new to options, is the covered call. With a covered call, a client who is long a stock or ETF would sell a call option, with a specific strike price and expiration date, against their underlying equity holding. Generally, if they own 100 shares, they could sell one call.
This approach provides immediate income for the client, but it also establishes a predetermined level (determined by the strike price) on the client's sales price. Another potential benefit to the covered call is that it lowers the client’s basis, as the premium income received for writing the call contract can be treated as a reduction of the original price paid for the shares. However, selling calls could have tax implications, so please consult your tax professional.
Covered calls could also be implemented if a client believes their stock price is peaking and they are willing to sell the stock at a predetermined level. With a covered call, the client must be prepared to sell their stock or ETF if it rises above the strike price. This is because covered calls bring assignment risk. When the buyer of the call option that your client sold wants to exercise, the client may be "assigned," meaning they are required to sell their underlying at the strike price. Another consideration with covered call writing is the opportunity risk of not participating in a possible rise in the stock price.
Protective puts and covered calls are often utilized by advisors and their clients, in part because they are considered one-legged overlays. The concepts are fairly straightforward, but there are many more choices.
In fact, one of the more notable aspects of options is their versatility. The first quarter in 2020 experienced an unprecedented surge in volatility. If an investor and their advisor had an opinion prior to the first quarter on the direction of the markets, they could have been very strategic and considered employing an option strategy, including one based on a potential increase in volatility or one built around a possible volatility decrease.
Many different options strategies are available today because the U.S. cleared options markets have evolved dramatically since the inception of a standardized options exchange in 1973. The Options Clearing Corporation (OCC) is the sole central counterparty for exchange-listed option trades on U.S. exchanges and acts as the intermediary between every buyer and every seller.
Thanks in part to all of the options exchanges and OCC's clearing capabilities, the options market has continued to grow over the years, and the first two quarters of 2020 had some of the most active months in history.
A Learning Journey
It takes time and dedication to learn about options, but they can become an integral part of an investing strategy. OIC provides numerous methods to assist in your educational needs, including free webinars, a self-paced Options Education Program and real-time chat dialogue with our Investor Services group. Another way to contact our industry professionals is by calling 1-888-OPTIONS or by sending an email to firstname.lastname@example.org.
Whether a client chooses to incorporate one-legged strategies, like writing calls or implementing protective puts, or creating more complex strategies with three or more options simultaneously, OIC offers the educational resources to cover almost every scenario.
Options involve risk and are not suitable for all investors. 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. None of the information in this email should be construed as a recommendation to buy or sell a security or to provide investment advice.
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