Choosing the Right Options

Schwab’s acquisition of OptionsXpress is a recent example of a changing trend. Like TD Ameritrade’s buyout of ThinkOrSwim, the move is an example of a large discount broker taking out a smaller niche player to get a larger piece of the options trading business. While some broker/dealers still frown on the product, the options industry continually sets new volume records every year and increasing numbers of investors are trading puts and calls. Are options suitable for every investor? Absolutely not. However, in some cases, adding options strategies can make a lot of sense for both the customer and the Registered Rep.

Although the popularity of options-trading continues to grow, the actual product hasn’t changed over the years. Buying a call option gives you the right to buy an underlying at a specific price for a period of time. Buying a put entitles you to sell the underlying at a strike price through the expiration. The basics of an options contract are straightforward. Yet, while Options 101 is easy to teach, many inexperienced investors lose money with options because other factors that affect options-prices are not well understood. For example, options are wasting assets and lose value due to time decay. Changes in implied volatility can also have a significant impact on options prices.

Due to the complexity and risks associated with options, many Reps stay out of the business altogether. Despite industry efforts to provide a host of free online and offline options-related education, the product is still not well-understood and is certainly not suitable for everyone. Many investors shouldn’t be introduced to options at all.

In some cases, however, it’s a mistake not to offer options as part of larger financial plan. While some investors use puts and calls merely to speculate on moves in the underlying, options can also offer a hedge and reduce volatility. Simply selling a call option against a stock position (a covered call or buy-write) is a less risky strategy compared to buy-and-hold investing. For that reason, brokerage firms will allow Covered Calls as a Level 1 options strategy in most customer accounts. Protective Puts and Collars are also examples of basic Level 1 strategies that make sense when the investor is looking for capital appreciation from shares, but once some downside insurance. Going beyond Level 1 strategies, options make sense for experienced investors that want to take positions in an underlying, but without sticking their necks out too far in volatile markets. For example, one popular strategy we see institutional investors initiating in today’s turbulent markets is a three-way spread, in which puts are sold to finance a call spread.

A recent example surfaced in Valero. Shares of the oil refiner were trading around $23 last week when one investor sold 10,000 January 16 puts on the stock at 56 cents. The put write was an opening trade and, by selling these puts, the strategist is saying that they’re a will buyer of the stock at the strike price – which is 30.4 percent below the spot. At the same time, they bought the January 24 – 30 call spread for $1.41, 10000X – which gives them upside exposure if shares rally beyond $24.

The three-way spread in VLO is a “smart money” play as it traded 15,000X (a combined 45,000 contracts), but it’s the type of position that also makes sense if an investor wants to buy the stock on a pullback, but also wants upside exposure in the name in case it rallies. For an 85-cent net debit on the three-way, there’s less capital at risk compared to buying shares. Of course, the account must be approved for put writing.

Options and advanced spreads are not suitable for many investors. Other times, however, not suggesting the product is also a mistake. Level 1 strategies like Covered Calls, Protective Puts, and Collars are strategies can allow for capital appreciation, but with less risk than buy-and-hold investing. Call spreads and bullish three-way spreads are trades that can provide upside exposure, but with less capital at risk compared to buying shares or call options. Calendar spreads, butterflys, and straddles are more advanced options strategies that can generate income to a portfolio or profit from changes in volatility. The first step before introducing the more advanced concepts is to fully understand the product and begin with the basic Level 1 strategies like covered calls.

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