Volatility could occur in the markets as investors wait for the outcome of the next Federal Reserve meetings and the U.S presidential election, but buying options can help hedge against big moves in the market.
While some investors shy away from volatility, others take advantage of the moves by playing defense and constructing hedges with options using a protective put or a protective collar, said Frank Tirado, vice president of education for the Options Industry Council, a Chicago-based industry cooperative. Traders who want to be offensive can buy straddles and strangles which helps them build a strategy for large movements in the market even if they do not have an opinion on either direction.
"For investors and traders who want to play defense, it is like buying insurance and you have a few choices to make," he said.
Options can be viewed like paying a deductible for insurance. Investors can buy options not just for stocks, but even to protect their ETF in case there is a drop in the value.
"Select your option by thinking about how large of a percentage drop you're willing to bear before you're completely protected such as a 10% or 15% decline in value," Tirado said. "Let's say your index ETF is trading for around $215 per share and that you're willing to 'self-insure' a drop of 10%. In this case, you'd be looking to buy a put option whose protection starts at $193.50, which is 90% of $215."
The level of the amount of which the protection starts is called the strike price of the option. If an investor finds that a strike price of $193.50 is not available, they could opt for a strike price of $195.00 or $192.50.
"When you overlay the put option on your ETF, you completely remove economic exposure to a price drop below the strike price, just as you do when you buy insurance on your car," he said.
Investors are often fearful of volatility because they witness the massive selloffs in equity markets, but instead should take advantage of it, said Russell Rhoads, director of education at the CBOE Options Institute, a Chicago-based educational arm of the Chicago Board Options Exchange. Put options are a good strategy to hedge against a large move to the downside.
"If you think options market is underpricing volatility, consider buying options and if the reverse is true and it is overpriced, consider selling options," he said.
The prices for put options increase the longer their duration, so if you want to protect your stock or ETF going into 2018, expect to pay more.
"On an absolute basis, short-dated options are less expensive than long-dated ones," Tirado said. "The price per day is higher, but the total price tag is less, because you're buying fewer days of protection. Put options can be purchased in weekly, monthly, quarterly and even longer durations and you can combine and adjust the mix of the insurance contracts you own as your view about the market changes."
Some investors welcome volatility in the market and purchasing a straddle can be a solution since traders do not have to hold an opinion on the direction of the stock, ETF or index.
Using straddles and strangles can be a method to capitalize on big moves in either direction, said Jim Haile, vice president of product management at E-Trade, a New York-based brokerage firm.
A long straddle is a two-part options strategy that includes the purchase of a call and a put at the same strike price with the same expiration date. The risk for this strategy is the combined price paid for both options.
"If your forecast is wrong and the stock, ETF or index does not make a large move in either direction, then you may lose your entire investment and therefore it becomes important to manage the straddle following the anticipated event," Tirado said.
Investors who want to follow a similar strategy, but do not plan to invest as much capital and requiring a bigger market move, should consider buying a strangle which is the purchase of a call and a put with strike prices that are above and below the current stock, ETF or index price, he said.
"Both straddles and strangles work the same way because investors profit with dramatic price movement in either direction because the put increases in value if a stock declines past the total cost of the strategy just as calls increase in value if a stock advances past the total cost of the strategy," Haile said.
The problem with these options is that not only are they some of the most expensive strategies, but investors only profit when the "stocks move more than the money spent to buy the entire straddle - which includes the total price for not one but two options," he said. "You are essentially paying more for a potential win for not one but two scenarios: if the price moves dramatically in either direction."