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By Scott Altschul, Senior Vice President, Florida District, Key Private Bank –
When you hear people talk about options, the dialogue is generally directed in one of two ways:
1. Options are effective financial instruments for managing risk.
2. Options are complex and risky.
As is the case with most things in life, the truth about options is not so black and white. They are complex financial tools that investors—both individual and corporate—can use for managing risk or to achieve increased returns. And while they do pose some perceived risks, when managed effectively by competent investment managers, options are excellent tools for targeting a variety of financial objectives.
Understanding derivatives and options
A derivative is a financial instrument whose value is derived from or depends upon the price of an underlying asset. An equity derivative is a contract between two or more parties in which the asset holder allows the option investor the opportunity to pay or collect a premium to later purchase or sell that asset at a fixed price.
These are called equity options, and investors use them to:
• Generate portfolio income,
• Protect portfolio gains,
• Hedge a stock concentration and
• Speculate on price movements.
There are two basic types of options: calls and puts. Call options give an investor the right to buy a stock at a predetermined price (strike price) at any point prior to the option’s expiration date. A put option gives the investor the right to sell it.
The covered call
A popular options strategy with high net worth investors is covered call writing. It is considered a conservative strategy, yet it offers many advantages. Basically, you sell a call on a position that you have just purchased or already own. Like with the sale of any item, you receive cash for the call, which is known as a “premium.” If the stock doesn’t reach the call strike price at maturity, the call seller has increased the yield on their stock with the added benefit of a small downside protection. If the stock does reach the call strike price, the call seller may be obligated to sell the stock, conceivably limiting the stock’s upside potential, or they can possibly roll into another call option. Covered calls can be used as a yield enhancement or as an exit strategy to sell the underlying stock above the current market price.
The protective put
The key to understanding the concept of protective puts or hedging using equity derivatives is the notion of insurance. While an insurance contract can provide protection against risk of loss, so can an equity put option. Individuals pay an insurance company a premium in order to obtain protection against future damage or harm. The same holds true for equity put options. They allow investors to pass on an unwanted risk (loss) to another party by paying cash in advance or by assuming a different risk. For instance, to protect against a significant decline in a large stock position, an investor can establish a floor for the stock’s value by purchasing a put option. Someone who invests in a put option is purchasing the right but not the obligation to sell a specified underlying item at an agreed-upon price within a predetermined timeframe.
There are two likely outcomes when utilizing a protective put strategy. The first outcome is that the stock or ETF (exchange traded fund) trades down below the strike price. If this occurs, at expiration the put option should appreciate in value to an amount approaching the amount of loss in the underlying investment, thereby mostly hedging the loss and protecting the value of the stock or ETF.
The other likely outcome is that the underlying investment appreciates to an amount greater than the strike price of the protective put option at expiration. In these circumstances, the put will expire worthless. In the event the underlying stock or ETF appreciates by an amount greater than the cost of the put, the cost of the put option will simply reduce the overall return by its cost.
Utilizing a protective put strategy can be an effective means to stay invested in a declining market.
A word on navigating options for the individual investor
Derivatives are not immune to tax law. There are potential tax issues to consider when using equity options as an investment strategy. In addition, even for experienced investors, the decision of which options strategy and particularly which options to use can be complex. So while derivatives can offer unique solutions to investors looking to minimize risk and even increase the yield on assets, the insight and expertise of a qualified professional is paramount to achieve optimal results.
Scott Altschul is senior vice president and investment solutions specialist with Key Private Bank’s office in Palm Beach Gardens, Florida. He helps high-net-worth clients manage and grow their wealth, leveraging the considerable resources of Key Private Bank’s local team of experienced financial professionals in various disciplines.
Scott has 20-plus-years of experience in the financial services industry, including experience as a portfolio manager for Merrill Lynch and a senior vice president of wealth management for a large financial institution. Prior to that, he practiced law for several years in New York.
A native of New York City, Scott earned his bachelor’s degree in economics from the State University of New York at Albany and a law degree from Hofstra University School of Law. He now lives with his family in South Florida.
An active member of the community, Scott has volunteered as a YMCA youth coach for baseball and basketball and has served on the board of directors for the Victory School in Miami. He sits on the Boca Raton Estate Planning Council and is a member of the South Palm Beach and Palm Beach County Bar Associations. He also has served on the professional advisory committee for the South Palm Beach Jewish Federation.
Key Private Bank provides a highly personalized approach to addressing wealth management issues and simplifying the financial lives of its clients. Specialized practice groups and a consistent, disciplined approach helps clients define their priorities and create individualized investment strategies that help them reach their goals. Service areas include financial planning, tax strategy, estate planning and insurance solutions.
©2012 KeyCorp
