How Options Can Help Reduce Risk

April 20, 2021

By: William “Bill” Speth, Chief Research Officer

At Options Solutions, we believe that owning stocks is still the best way to increase wealth and prepare for the future.  Yet, as we have seen all too often, the stock market can experience dips, bumps, and sometimes bone-rattling volatility that can make some investors question whether the risk of owning stocks is worth the historical reward.

In our view, the appeal of owning stocks – at least since the 2008 Financial Crisis – is almost undeniable.  Since 2010, the Standard & Poor’s 500 Index has appreciated at an annual compound growth rate of 11.6%.  On April 1, the S&P 500 closed above 4,000 for the first time ever and is up over 10% through April 13 this year.  (Data source: Bloomberg).

Yet, last year’s COVID-19 market decline stands as a stark reminder that stock prices do fall – and sometimes fall rapidly.  So, with stocks at all-time highs, what can investors do to protect the value of their stock holdings?

How the Disciplined use of Options can Help Reduce Risk

There are any number of ways to use options to protect, or “hedge,” the value of an equity portfolio, and each carries a different balance of effectiveness and cost.

We believe that the simplest and most direct hedge is to buy put options on your stock holdings.  The owner of a put option has the right to sell shares at a pre-determined price known as the put “strike price.”  A put generally increases in value as the underlying stock price falls and as such can provide protection against losses below the put strike price.  While direct and effective (if stock prices fall), buying puts can be among the costliest ways to hedge an equity portfolio and can create a meaningful drag on performance especially if the hedge is maintained over a long time.

To offset the cost of simply buying puts, investors can enter into a strategy known as a put “spread,” which involves buying a put option and selling another put with a lower strike price. This strategy can provide protection over a range of prices beginning with the strike price of the put that was bought and ending with the strike price of the put that was sold.

The put sale partially offsets the put purchase and can reduce the overall cost of the hedge.  The trade-off is that a put spread only hedges against losses within the protection range – but not below.  Put spreads can be an effective way to hedge against most smaller market corrections of 10% to 20%. Yet, even at reduced cost, hedging with put spreads can create a drag on portfolio returns.

Another hedging strategy – the one that we prefer – involves combining the sale of a call option with the purchase of a put or put spread.  The reason we like this strategy is because it can be constructed with no initial cost.

There is, of course, a trade-off – when you sell a call option, you agree to sell shares of a stock at a pre-specified price.  In effect, you are selling the upside potential of your shares to pay for downside protection of the put or put spread.  And the more protection you want, the more upside you can expect to give up.

The hypothetical example above illustrates the potential investment outcomes of the “zero-cost” hedge.  Importantly, the strategy is not intended to protect against a major stock decline.  Also, the strategy can limit upside appreciation compared to an unhedged position.  The benefit, however, is that the hedge can be held for a long period without certain recurring up-front costs.

We believe that investors can achieve an effective balance of protection and potential upside with the purchase of a put spread (a “protection buffer”) and the sale of a call option.

Why? Because in our view, few investors need to protect the full value of their stock as most stock declines occur over a range.  Also, since put spreads generally cost less than comparable put purchases, the call option can be chosen with a higher strike price with greater upside potential.

We understand that every investor is different, with unique investment objectives and risk tolerances and we work with you to find the right balance.  With so many different combinations of options from which to choose and as many trade-offs to consider, experience is key in constructing a cost-effective options hedge.

Stay tuned for how to sell above the market price and below the market price.

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