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Options: A Marriage of Necessity

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September 1, 2014

Portfolio diversification is typically explained as not putting all your eggs into one basket. The problem is, too often those “eggs” roll in the same direction, especially if you’re clinging to a traditional stocks-and-bonds model. But a basic options strategy can help avoid that trap.

EDITOR'S NOTE: This is the first article in a three-part series on using option strategies for portfolio diversification.

Everyone wants to be diversified, right? You probably already know that diversification can be a powerful tool for helping to manage risk and smooth out returns. However, it only works if your assets are not all positively correlated—meaning, if they don’t move in lockstep. But even stocks that aren’t correlated today can become so tomorrow, and during periods of widespread bullishness, the rising tide tends to benefit most bullishly positioned investors. What happens in an opposite, bearish scenario? Trouble, that’s what.

Longstanding assumptions and realities about diversification have been altered by a number of developments in recent years: the 2008 global financial crisis, the Federal Reserve’s near-zero interest rate policy, and other factors. That means today’s diversifiers must adapt, become more nimble, and consider alternatives, such as options.

Options may come in handy for investors who are comfortable using them and understand the potential risks.

Hedging Strategy

Every investor is subject to shifting risks and market volatility. So whatever the market conditions, it’s important to seek out assets that maintain a negative correlation (tend to move opposite) to other components of a portfolio. In other words, if you need something that is designed to increase in value when the market sells off, put options may be just the ticket.

Put options are designed to increase in value when the price of the underlying stock drops, and any profits can help offset losses from the underlying stock. When properly applied, put options can offer a truer hedge than traditional diversification methods, providing a measure of protection for a limited period of time against a major bearish news event or broader market slide that drags down all stocks.

Let’s start with a very simple example. The stock of XYZ Corp. is trading at $50 a share. In the options markets, we find a host of number combinations, but let’s initially focus on the strike price, and there are several from which to choose for a typical stock. A put option with a 50 strike is considered “at the money,” given the current price of the underlying stock. If you buy one 50 strike put and the stock drops to $40, the put now has an “intrinsic” value of about $10. You could then sell the put contract back at a profit, minus transaction costs.

Information on strike prices and other put and call details is easily accessible by logging into your account through TD Ameritrade platforms such as Trade Architect® (see figure 1).

FIGURE 1: PUT ER THERE. For the stock in this example, put option strike prices (yellow circles) are available in 50-cent increments. Source: Trade Architect. For illustrative purposes only.

Getting Hitched

Taking this a step further, we have the “married put” (aka protective put), which is the purchase of put options and the underlying stock representing an equivalent number of shares at the same time (see figure 2). The basic idea is the same—using puts to help protect against potential stock losses.

For example, you buy 100 XYZ shares at $50 and concurrently “marry” that position with the purchase of a 50 strike put (one options contract typically represents 100 shares). XYZ then climbs to $55, meaning your put option is now “out of the money.”

If XYZ continues rising, obviously that’s good news for your stock investment. But you’ve still got that increasingly out-of-the-money put, right? Not to worry—As long as the stock price stays above $50, your put expires worthless. You’d be out the premium paid for the put (49 cents a share, or $49 total, in this example), plus commissions and fees (probably another $11 or so in this case, for a total cost of about $60). Take note: Transaction costs (commissions and other fees) are important factors and should also be considered when evaluating any options trade or strategy.

FIGURE 2: OPTIONS STRATEGY MENU. The protective, or married, put, along with other option combinations, can be found by clicking on Select Strategy under the Options Chain tab. Source: Trade Architect. For illustrative purposes only.

However you slice it, the put option hedges your stock in a way that diversification cannot, many market professionals say.

“Protective puts can be useful when trying to manage risk in a portfolio if you are anticipating a market downturn,” said Ryan Campbell, Content Manager with Investools®, the education affiliate of TD Ameritrade. Additionally, out-of-the-money puts (those with a strike price below that of the underlying stock) can make hedging cheaper, although it’s best to view the associated premiums and fees as a sunk cost and “accept the loss up front,” he added.

The Long View

Ultimately, it’s important to recognize that it’s virtually impossible to prevent all losses. Eventually, everyone takes their lumps. But judicious use of put hedges can be a smart approach in turbulent markets.

“The purpose of hedging with puts is to help manage risk,” Campbell said. “If the market rallies, you just accept that the money spent on buying the puts was the price you paid for protection. If the market falls, then it’s some of the best money spent.”