Options can help limit an investor's downside losses, especially during periods of increased volatility and uncertainty in the market.
Options are another strategy which provides investors with a "great way to hedge investments in their portfolio and generate income," said Michael Berger, founder of Technical420, a Sarasota, Fla.-based company which conducts research on cannabis stocks and is a former Raymond James energy analyst. "I like to compare options to an insurance policy as you can insure your investments against a downturn in the market."
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"Investors can also purchase a straddle, which is a call and put option, so you capitalize on wild price movements to both the upside and downside," he said. "These positions are perfect for investors looking to capitalize on short term, volatile price movements like we saw last week."
Options such as puts can also help investors who are seeking to boost their retirement portfolios while lowering their risk.
Purchasing options can be seen as an insurance for equities in a retirement portfolio, said Jim Haile, a vice president of product management, E-Trade Financial, a New York online brokerage.
"In the same way that homeowners purchase insurance to safeguard against catastrophes, options can act as insurance by limiting potential losses for a premium," he said.
When investors buy a put, the cost of the option is called a premium, following the same terminology used by the insurance industry.
"Each option has a limited life, just like a home insurance policy and serves as a protection if the stock or index falls below a certain price," Haile said. "The difference between the current price of the stock and the protection level known as the strike price could be viewed as an insurance deductible."
The expense of premiums depends on the current market conditions and whether there is a high level of volatility, especially after unexpected global news occurs, such as the U.K. Brexit vote to leave the European Union when the repercussions are unknown and the levels of uncertainty can be high.
"During quiet markets, insurance is cheap," he said. "When markets face potential upheaval, insuring your portfolio can be more expensive."
How to Leverage Options
Since the use of options requires a "degree of know-how," not all retail investors should implement the strategy, said Edison Byzyka, chief investment officer of Hefty Wealth Partners in Auburn, Ind.
Retail investors can purchase out-of-the-money puts on broad indices as many seek to minimize or attempt to eliminate the downside, he said.
"Options can prove to be beneficial in that regard," Byzyka said. "The risk lies in the fact that the market may never experience a downside during the time frame, causing investors to lose their premium."
Bullish investors seeking to generate additional income can leverage options as part of their long-term investing plans.
"They believe that the market isn't going anywhere quick and writing covered calls help them generate income even as the market stays where it is," Haile said.
Slightly bearish investors might be concerned that the market has peaked and many of them opt to buy puts or collars, which allows them to "hedge their emotions and make them feel a bit safer about riding out market swings," he said. Utilizing index options such as the CBOE S&P 500 BuyWrite (BXM) to hedge the equities in their portfolio can be one strategy.
While some investors feel as though they are "late to the party" and have been sitting on the sidelines because of their bearish outlook and missed the rally, they could sell puts below the market to make up for missing the increase, "provided the market stays where it is or continues to rise," Haile said.
Too Much Leverage
Overleveraging a portfolio does not shield investors from all losses in the market, and purchasing too many options just because "they are cheaper than the stock can be compared to buying flood insurance when you don't live in a flood zone," Haile said. While investors who own stocks can hold them forever, options are limited to a defined period of time like purchasing futures.
Buying a covered call option writing strategy could prove to be profitable for investors who hold large individual equity positions and are reluctant to sell either for sentimental or tax reasons, Byzyka said.
"This approach allows the investors to receive a premium and the investor bears the risk that the option will be exercised, causing the eventual sale of the stock," he said. "Writing options is not for everyone and can be risky in the event of unexpected market volatility."
Another strategy to prevent large losses is by purchasing long-term LEAPS, said C.J. Brott, founder of Capital Ideas, a registered investment advisor in Dallas.
"This usually makes sense if the investor has a large gain and wants to protect it," he said. "Then the investor can sell the position and reinvest a limited portion of the proceeds in a long-term LEAP option to participate in any ongoing gains."