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) 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) or Tesla (TSLA) are going to be more expensive compared to companies such as AT&T (T) , 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.