Selling options can help investors benefit from the volatility in the market and mitigate the risk in timing the price of the stock.
Instead of buying options, selling them might be a better way to hedge against volatility, said Ron McCoy, a portfolio manager of the LOWS fund (Levered Options Writing Strategy) on Covestor, the online investing company and chief investment officer at Freedom Capital Advisors in Winter Garden, Fla.
"With the increasingly cheaper commissions being offered by many brokerage firms, options trading has been on the rise," he said. "For investors, that can be a blessing or a curse depending on which side of the trade they are on."
Too many investors rely heavily on buying a call or a put and hoping their timing is right, McCoy said.
"Unfortunately for many investors, their timing is off and or the stock moves the other way and they lose their original investment," he said.
Selling puts is akin to selling insurance, because the seller or writer is being paid a premium to assume the additional risk. Since the buyer of the put pays the seller a premium for each contract sold, the buyer has the right to exercise his option at any time. On the flip side, the seller has an obligation to buy the stock or index at the strike price at anytime prior to the expiration if the buyer exercises his or her right.
Diversification is critical and investors should stick to a strategy of only selling puts on stocks or indexes they want to own and at prices they are comfortable with, said McCoy, whose LOWS fund returned 25% last year and is up 4.5% for the first quarter. The LOWS fund sells puts on several different companies.
"The WisdomTree CBOE S&P 500 Put Write Strategy (PUTW - Get Report) sells or writes at-the-money puts on the S&P 500 and does not use any leverage," McCoy said. "They closed out the first quarter with a 3.7% gain."
When volatility increases, options sellers can often increase their profits. Investors need to be aware that options on stocks such as Amazon (AMZN - Get Report) or Tesla (TSLA - Get Report) are going to be more expensive compared to companies such as AT&T (T - Get Report) , a utility that typically lacks wide swings in its price.
Time is another factor that can impact the price of an option. An option that expires in one month will be a fraction of the price of what an option trading six months out is trading for, he said.
"In some ways, it's like getting paid for a GTC (good-till-cancelled) order," McCoy said. "I caution investors against taking on too many or too heavy of positions, especially average retail investors and particularly if the investor is using leverage. They say time is money and it truly applies in the options market."
Writing also known as selling options can reduce the amount of risk by offsetting part of the capital invested in the underlying assets, said K.C. Ma, a CFA and director of the Roland George investments program at Stetson University in Deland, Fla. The writers or sellers of call or put options will receive the option premium, which is the maximum profit they will get.
"The premium can be used to reduce the cost base of the investments in the underlying stocks," he said.
While there is a limited upside, sellers of options should be cautioned that there is a greater downside loss because you could lose than more than 100% of your original capital invested."
Writing options to generate higher returns comes with a large amount of risk and "collecting an immediate payoff is not as easy as it sounds," Ma said.
"If you want to buy Nvidia at $100 and also somewhat hedge the risk, you may choose to sell June put at the same time you buy NVDA, which will reduce your total cost from $100 to $90 of owning the stock," he said.
If Nvidia's stock rises to $110, the investor who bought the put from you, will walk away and leave the put useless, Ma said.
However, if the direction of Nvidia heads the other direction and drops to $75, the same investor will come back to "sell you the stock at $100 and you will realize a net loss of $15 or a 150% loss per the $10 premium you collected before," he said.
"Options writers are often compared to the house of a casino," Ma said. "It only makes sense if you have the large cashflow to pay out in the short run. Remember, in the long run, the house always wins."
Shorting the indexes is one strategy to profit from increased volatility, but most investors are not comfortable doing because of the increase in risk, said Meredith Zidek, a Hunt Valley, Md.-based options and ETF trader.
"Red ink on an ill-timed short trade could become substantial and might never be erased, leaving the trader take a painful loss," she said.
The amount of losses can be limited when selling puts, giving traders who are bearish about the stock indexes another short-term strategy. SPDR S&P 500 ETF Trust (SPY - Get Report) was trading at $233 on April 13 and an investor could have purchased puts for the $232 strike at the May 12 expiration for $3.00 per contract, Zidek said.
"Simply buying a put would require SPY to fall lower than $229 in order for the contract holder to do better than break even on that position," she said. "To reduce costs, $228 strike puts for the same expiration could be sold, bringing in about $1.96 and this lowers the total cost and the maximum possible loss of the spread to $1.04 per contract."
Traders who believe that volatility in SPY is "resolving or at least would not mind buying SPY shares at a predetermined price could make things simpler" and just sell puts instead, Zidek said.
"A rise in SPY above the selected strike would bring in the premium with no obligation to take on shares," she said. "In the other event, a decline of SPY below the strike would result in shares being put to the trader, if carried through expiration, with a premium received to set against any price disadvantage that may exist when the shares are put to the option holder."