Last week’s sell-off in the markets sent investors a loud-and-clear message that markets don’t go straight up all the time. There were tons of articles trying to assign “blame” for the bump that pointed to the turmoil in emerging markets or the expectation of another debt ceiling conflict in Washington.
Forget trying to understand why. Savvy investors are likely realizing this truth about investing, and exploring the use of options to express their directional bias in the market in a hedged manner.
There are three primary reasons options exist as investment vehicles:
In my opinion, hedging — or changing the risk profile of straight stock ownership — is the #1 reason.
This is why when there is the first whiff of trouble in the market (trouble being defined as bearish selling pressure), the VIX volatility index tends to spike higher. This index has been called the Fear Index, but to me the VIX simply measures the demand by investors of a desire to hedge their straight stock ownership. When demand for a hedge is low, the VIX index is low. When investors demand for hedging is high, the VIX shoots higher.
Using options allows investors to have exposure to price appreciation (or price declines) in equities with limited downside risk exposure either through buying protective puts on shares they own, or by replacing their long stock positions with in-the-money Stock Replacement Call options. While option buyers do risk 100% of the premium they pay for their options, the amount paid to own the right to buy the stock is typically a fraction of the cost of outright buying the shares.
The full description of the Stock replacement strategy is spelled out in an archived webinar entitled Options 101: Long Calls.
Most straight stock traders have only two investment choices: to be long stock, or not to be long stock. Timing the markets can be a no win situation, many traders sell out (capitulate) at the bottom and miss out on any recovery in prices. Or these traders hold on, hoping for a bounce, too long in an extended bearish market. Using options to gain hedged exposure may be a more compelling “option” (yes, pun-intended).
The OptionsHouse webinar archives have a special section devoted for you stock traders teaching the basics of how options can change your risk profile away from straight stock ownership. I encourage you to take advantage of this free education. The full menu of archived sessions can be found here.
The markets are getting bumpy… Might be the time to be hedged out there!
While all options trading involves risk, some strategies have more potential risk than others. It’s important to understand each strategy and know the risks before you trade.
The above information is provided by OptionsHouse for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Results may vary with each use and over time. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.