Options trading. The mere mention of it strikes terror into the hearts of most stock investors.
But options trading doesn't need to be fear-inducing. In fact, options can be an effective tool for managing your risk in this market -- and a way to protect against the next surprise crash in stocks. Best of all, options do that while also keeping downside risks fixed and finite.
Most people think of options as a way to increase both the risk and reward of a directional trade. In other words, if you think that a stock is heading higher, buying call options on that stock can increase the upside potential if you're right.
And while that's true, it's also true that making money with vanilla options isn't easy. A large proportion of options expire worthless.
Part of what makes buying options so hard is the fact that there's both a direction and time component to them. Not only does your investment thesis need to play out correctly for you to make money, but it has to happen in a preset timeframe, too.
But there's another way to think about options.
Options are, effectively, an insurance policy for your portfolio.
Just like with car insurance, you pay a premium to purchase an option. If the market consensus is that the option is likely to have to pay out, then the premium you pay is higher (just like trying to insure your teenage son to drive your Ferrari).
There are two scenarios when it makes sense to buy insurance: When you're able to buy a policy with cheap premiums but that's still very likely to pay out (that is, positive expectancy), or when you need to protect against unlikely losses that would be catastrophic (this is why we have homeowners and car insurance).
The same general idea exists when using options to protect your portfolio.
Here's a simplistic example.
Let's say you started off 2018 worried that we could see a 30% drawdown in the S&P 500 sometime this year. You could have bought S&P 500 SPDR ETF (SPY) January 2019 $225 puts back in January, when volatility was dirt cheap, for $3. If the S&P 500 did retrace 30% in the year that followed, those puts would have intrinsic value of $25.50 at expiration, returning $2,550 for every $300 contract purchased.
That's a huge gain, but it requires a big loss in the S&P 500 to see a payoff.
That doesn't mean that it's impossible to see a payoff in the interim. For instance, the recent swift correction in the S&P 500 rocketed those SPY $225 puts to as high as $11.50 earlier this week, as volatility got more expensive. Simply, traders ramped up their odds that those put options could move into the money by expiration.
In other words, it's possible to be opportunistic and sell your puts during market shocks.
An option with a higher strike price would come with a bigger premium in exchange for a bigger payoff in the event of a market drop.
And like a regular insurance policy, you're only out the premium.
The big caveat is that premiums are constantly changing. This week's volatility re-alignment increased the premiums on put options substantially. The higher the VIX, the higher traders see the odds of that "insurance policy" paying out, and the higher the premium will be. That means that the economics of whether it makes sense to hedge with options changes day-by-day.
One consequence of that is that there aren't any free lunches in hedging -- a portfolio hedge that's overwhelmingly likely to pay out is just as likely to come with a premium that's ruinous for your portfolio if the market doesn't roll over. At that point, you're basically making a short bet on the market, not a hedge.
For that reason, it's crucial to evaluate the profit and loss scenarios with any option position in real time. Changes can and do happen fast.
Despite the fact that options are often seen as a risky investment, they actually have a valid use as a way to insure your portfolio against a market crash and actually reduce the overall risk of the market. Finally, bear in mind that this primer just scratches the surface -- there are many more factors to take into consideration out there.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.