Options give investors the right to buy or sell a particular investment at a fixed price by a certain date.
Options may be able to effectively generate steady monthly income while maintaining exposure to stocks.
From flexibility to risk management, options offer a range of potential benefits for an investment portfolio.
Investment portfolios may include stocks, bonds, commodities — even cryptocurrencies. More investors are also turning to options as useful tools for generating income and helping reduce downside risk. The potential benefits extend even further. And professionally managed options-based strategies through exchange-traded products (ETPs) have never been easier to access. Let's look at what options are and how they work.
Options are a type of financial instrument that gives an investor the right — but not the obligation — to buy or sell a set quantity or dollar value of a particular investment at a fixed price by a certain date. The name comes from the choice (or option) received in the agreement.
Option contracts are two main types: call and put.
The buyer of a call option believes the price of the underlying asset will increase in the future. If the asset price rises above the strike price during the specified term, the buyer can exercise the option. In other words, the investor can buy the asset at the lower strike price and sell it at the higher market price for a profit.
The buyer of a put option believes the price of the underlying asset will decrease in the future. If the asset price falls below the strike price before the option expires, the buyer can exercise the option. In simple terms, the investor can buy the asset at the lower market price and sell it at the higher strike price for a profit.
When an investor sells an option, they give the buyer the ability to buy or sell a specific asset by a certain date at a predetermined price. In return, the seller collects an option premium from the buyer. That’s considered income. Option income strategies can effectively generate steady monthly income while maintaining exposure to stocks.
Option income has a different set of sensitivities and drivers than income from dividend-paying stocks or traditional bonds. For example, a primary risk of traditional bonds is interest rate risk, which the Federal Reserve (Fed) has increasingly influenced. Stock options avoid interest rate risk and can deliver high income regardless of interest rates or the Fed’s actions. Instead, option income is impacted by stock market volatility and strike prices. High stock market volatility leads to higher option premiums (and vice versa).
Options can serve a broader purpose in a portfolio. Here are five other potential benefits.
Options let investors control a large position with a relatively small investment. This leverage can amplify potential returns, helping investors benefit from price movements without committing substantial capital.
Investors use options to protect against potential losses in their portfolios. Put options, for example, can offset, or hedge, declines in the value of their underlying assets.
Buying call or put options lets investors bet on price movements without owning the underlying asset and potentially reap significant rewards if they’re right.
Options offer a variety of strategies for different market conditions and investment goals ranging from conservative income generation to aggressive growth.
Options can be used to strategically fine-tune a portfolio’s risk profile, managing exposure to market volatility, interest rate changes, and other types of risk.
Options are far from risk-free, especially for an inexperienced investor. Here are five inherent risks.
Options trading requires a deep understanding of various strategies, market conditions, and pricing models, which can overwhelm inexperienced investors.
Options are time sensitive, and their value diminishes as the expiration date approaches. Even if the underlying asset moves favorably, the option may still lose value if it doesn’t move quickly enough.
While leverage can amplify gains, it can also magnify losses. Investors using options to leverage their positions may face significant losses if the market moves against them. Therefore, fully collateralizing or “covering” options may be appropriate for managing leverage risk.
Options on less popular underlying assets may suffer from low liquidity. This can make it difficult for investors to enter or exit positions at desired prices, potentially leading to unfavorable trades.
Trading options can involve higher transaction costs and fees than trading other investments, particularly if the underlying stocks are less liquid. Additional costs can reduce potential profits and make frequent trading less viable for investors.
Investors who understand options and want to include them in their portfolios can get exposure to them in a variety of ways.
Investors can buy and sell options through online brokers and specialized options trading platforms. They must apply for trading privileges, which may require meeting certain criteria and passing a test.
Investors looking for a more hands-off approach can work with a financial professional with expertise in options trading. They can help develop and execute options strategies tailored to the investor’s financial goals and risk tolerance.
For investors who want exposure to options without directly trading them, ETPs that use options strategies can make sense. Funds like Invesco QQQ Income Advantage (QQA) and Invesco S&P 500 Equal Weight Income Advantage (RSPA) are managed by professionals who use options to potentially enhance returns, generate income, and mitigate risk. This method can provide a diversified and less complicated way to add options to your portfolio.
A financial contract that gives the holder the right — but not the obligation — to buy a specified amount of an underlying asset (usually in groups of 100) at a predetermined price within a set time period.
The date when an options contract becomes void and the right to exercise it no longer exists, ending the contract.
An options contract with intrinsic value, meaning a call option’s strike price is below the current market price of the underlying asset, or a put option’s strike price is above the current market price.
The price that the buyer of an options contract pays to the seller for the rights conveyed by the option.
An options contract without intrinsic value, meaning a call option’s strike price is above the current market price of the underlying asset, or a put option’s strike price is below the current market price.
A financial contract that gives the holder the right — but not the obligation — to sell a specified amount of an underlying asset at a predetermined price within a set time period.
A trading strategy that involves simultaneously buying and selling two or more options contracts on the same underlying asset with different strike prices, expiration dates, or both to limit risk and potentially enhance returns.
The predetermined price at which the options contract holder can buy (a call option) or sell (a put option) the underlying asset.
The financial instrument, such as a stock, bond, commodity, or index, upon which the value of an options contract is based and which the option holder has the right to buy or sell.
ETFs can be tax efficient because they rely on an in-kind creation and redemption process that helps limit capital gains distributions and investor taxes.
The fair market of an ETF may be gauged by its net asset value (NAV), which is based on its underlying assets, leading to premiums and discounts.
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Image: Credit: J. Anthony / Stocksy
All investing involves risk, including the risk of loss.
An investment in options involves risk and may not be suitable for all investors.
There are risks involved with investing in ETFs, including possible loss of money. Index-based ETFs are not actively managed. Actively managed ETFs do not necessarily seek to replicate the performance of a specified index. Both index-based and actively managed ETFs are subject to risks similar to stocks, including those related to short selling and margin maintenance. Ordinary brokerage commissions apply. The Fund's return may not match the return of the Index. The Funds are subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Funds.
Past performance does not guarantee future results.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Financial leverage refers to the use of debt to acquire additional assets.
A decision as to whether, when and how to use options involves the exercise of skill and judgment, and even a well-conceived option transaction may be unsuccessful because of market behavior or unexpected events. The prices of options can be highly volatile, and the use of options can lower total returns.
Click here for a QQA prospectus. Click here for a RSPA prospectus. Please read these carefully.
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