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4 reasons to use options -- and 4 more reasons why you should think twice

Options can smooth the bumps inherent in longterm investing but expect to take some time educating your clients about them

Friday, February 24, 2012 – 4:17 PM by Rob Isbitts
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Rob Isbitts: Options typically require far less capital than inverse ETFs used to hedge.

Over the past decade, investors and their advisors have had to decipher a lot of concepts. Think about it: who knew what QE2 was? Not a gigantic ship, but a method of loosening up credit markets (or trying to). Exchange-traded funds? Many people still confuse the term with Electronic Fund Transfer (EFT). And how about what the oil traders call the “crack spread?” Enough said.

Through the alphabet soup of Wall Street terminology, one area of investing has been, and continues to remain, as misunderstood as any: Options. In particular, I am talking about put-and-call options listed on the public exchanges, not the privately constructed type at the core of the sometimes controversial “structured notes.” I have used options in client portfolios for years, and I am a firm believer that they can, in certain circumstances, be one of your client’s best friends.

There are many reasons to use options as part of your practice. See: Buy alternative investments and get over Madoff, especially as interest rates threaten to rise: columnist. But there are also some important considerations which may cause you to think twice about employing them. Keep in mind that there are many angles from which to explore options usage. I will only scratch the surface here, and will focus only on options usage for investors, not for traders (since I am an investor, not a trader, and there are many, many articles you can read on options for trading).

Here are both sides of the story, so you can debate yourself on the topic.

Potential positives

1. Reduce the impact of major market declines

As we learned in 2008, nothing is “safe” in investing. Actually, advisors have been saying that as a meaningful disclaimer for years, but it took the horror shows of autumn 2008 and early 2009 to get people to take it seriously. Since the stock and credit markets now clearly have everyone’s attention, one of the most sought-after items in many portfolios is something that can potentially offset the natural flogging that any equity portfolio is likely to experience when markets turn upside down next time ( and yes, there will be a next time).

This is where purchasing put options on an index, such as the S&P 500, can be very helpful. Options are now also available on many ETFs, so if you have heavy exposure to an industry or sector. See: Winter winds hitting bond investors, China takes a pass, alternatives posted strong gains: Morningstar data.

2. “Collaring” to reduce the potential risk of taking a risk

Let’s say you want to take a position in a stock or ETF that you believe can be a huge winner in coming months or years. You would love to own it, but your generally conservative nature (or more importantly, that of your clients’) has prevented you from taking the plunge. Options may help. Specifically, you can buy the security and structure a “collar” around it. That is, along with the purchase of the stock or ETF, you buy a put option on that same security. This establishes a finite loss-point on the position. Since that “insurance” on the position costs you some money, you can offset some of that cost by selling (also referred to as “writing”) a call option on the security at a price above the current price of the security. While this will limit the amount of upside you will have on the position, at least you get to choose how high or low that upside limit is. Again, I am just touching on some desired outcomes from the use of options, as the mechanics that go into creating something like this structure are beyond the space limits of this article.

3. To keep portfolio turnover low, and maintain a core “long” portfolio

Even if you use options you are probably wondering why I relate their usage to reducing portfolio turnover. As I see it, a 21st century portfolio has two very distinct segments — a long side, which contains a core group of holdings (stocks, ETFs, mutual funds). This segment can potentially experience low turnover IF its volatility can be offset somewhat during times of market turmoil. That makes the second segment of the portfolio similar to what I described in number 1 above. Buying put options on indexes that resemble the composition of the core portfolio can potentially shield that core portfolio from some of the bumps and bruises that are a natural part of long-term investing. If you think of them in this way, you can be more patient when the core portfolio gets dragged down by market volatility. I find this to be especially useful in portfolios that produce a lot of cash flow via dividends. If you want to reduce risk in a portfolio that is targeting above-market yield, and that requires selling down your equity holdings in bad markets, there goes your income. But if you hedge away some of that volatility while allowing those dividends to keep coming, you not only keep the client’s income in line, you don’t spend a lot of the portfolio doing so. See: How RIAs can best pick alternative investments: Punt.

4. Lower the out-of-pocket cost of hedging a portfolio

Options typically require far less capital than inverse ETFs used to hedge, yet can protect similarly in big market corrections. See: Step-by-step on finding a platform for alternative investments.

Potential negatives

As I see it, the positive features of options take some time and focus to explain. The negatives are more straightforward, due to options’ [undeserved, but real reputation] for being risky or for gamblers only. Here are four immediate concerns for any advisor considering the use of options, even for the relatively benign activities discussed earlier in this article:

1. Options have a reputation with the investing public

Whether that reputation is based of emotions or fact, it doesn’t matter to you. But when you start to discuss options with a relatively inexperienced investor, be prepared to do a lot of educating. While the concept of insuring a portfolio against loss, reducing the cost of hedging, etc. can ultimately be a brilliant and appreciated breakthrough for the client, it often comes after some initial hesitation.

2. It costs money and you can certainly lose all of what you put up

To put this in context, let’s say that a put option you purchased for a[[ $1mm]] portfolio cost you 1% of that portfolio’s value, or $10,000 (but gets you $100,000 in “notional exposure” to what you are hedging). If the market goes up and up and up, and the options expire worthless, your client is out $10,000. That’s how they are likely to see it. Now, if you instead had decided to put on a 10% position in an inverse ETF ($100,000 investment), and the market goes up by 10%, do the math — you are still out $10,000. But psychologically, I have seen many times where losing 10% of $100,000 is looked at less critically than losing all of $10,000. Same thing? Ask your client.

3. Systems companies have not figured out how to correctly handle options

If there is one out there that does, I’d like to know about it. What I have seen in 25 years of viewing portfolio management and trading systems (two decades ago, I was in the systems business) is that options’ different structure vs. stocks and bonds makes them a pariah when these systems try to make the easy to use. As a result, you may face problems such as failure to recognize the hedge effect of owning puts (in account analysis), and inability to use them effectively in model portfolios. When I was managing mutual funds, using options was much easier than with separate accounts, since in each fund only one trade needed to be done, since the fund was one big account. If you have 50 separate accounts that are buying or selling the same contract in the same proportion, its much more difficult to pull off efficiently. See: The alternative investments sales cycle for RIAs got longer but marketing patience got shorter.

4. The educational battle may not be worth it

Inverse ETFs have survived some pretty volatile and dislocated markets so far. So while they take up more room in a portfolio than an option contract would for the same dollar impact, ETFs are much more straightforward. Options can be a terrific practice differentiator but you also have to balance that against the time and effort needed to include them in your portfolios, and the additional educational work that is likely to accompany their use. Whatever you choose to do, at least we can appreciate that there are alternatives ways of investing and protecting portfolios for risk-averse clients. see: The top 10 alternatives to alternative investments.

Read more columns by Rob Isbitts here.

Rob Isbitts is the founder and chief investment strategist of Sungarden Investment Research, and offers advisory services through Dynamic Wealth Advisors. Rob is a 25-year investment industry veteran, author of two investment books, creator of several portfolio strategies, and former chief investment officer and mutual fund manager. He currently advises a limited number of high-net-worth private clients and provides outsourced investment strategy and research services to financial advisors from South Florida. Rob can be reached at risbitts@dynamicwealthadvisors.com.

Elmer Rich III

Elmer Rich III

February 27, 2012 — 7:30 PM

Have to say, the folks we know, personally, making money now with their investments are doing options.

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