Changing market narratives in the third quarter led to ongoing market volatility. Those investors wishing to potentially dampen or even harness volatility may want to explore the potential benefits and risks of adding options to their portfolios.
“The benefits of diversification were evident as markets reacted to the volatility of shifting, rotating, and changing narratives,” explained Brent Joyce, CFA, Chief Investment Strategist and Managing Director, BMO Private Investment Counsel Inc., in an August global market update.
In an environment of elevated inflation and interest rate risk, ongoing geopolitical risk, and more, volatility spiked. While some investors pursued hedges against ongoing volatility, others sought to put volatility to work for their portfolio through options and options-based strategies.
Options-based strategies have grown in popularity with investors in the last few years as more funds have come to market. As of 09/12/24, FactSet has 359 ETFs with a composite AUM of $72 billion in its equity Buy/Write category alone, per FactSet.
Options fall into two basic types: call options and put options. A call option gives the purchaser the right, but not the obligation, to buy an asset at an agreed-upon price (strike price) by an agreed-upon date (expiration date). A covered call entails owning the underlying asset and writing a call on it. The underlying asset may already be owned, or it can be bought at the time of writing.
A put option gives the purchaser the right, but not the obligation, to sell an asset at a strike price by the expiration date. A protective put entails owning the underlying when buying a put. In both scenarios, the holder/purchaser is not obligated to exercise their option and may instead let it expire. Call options tend to favor bullish outlooks, while put options favor bearish ones.
Earning Income on Increased Volatility
Call and put option sellers/writers earn premiums on the options they write. This premium is in exchange for the additional risk they take when writing the option. In the case of a call, this risk occurs when an underlying asset appreciating in price is called away. For puts, it’s the risk of buying an asset depreciating in price.
Notably, trading strategies that write options may prove beneficial during periods of volatility because of their premiums. As market volatility increases, premiums earned from option writing also typically increase. This compensates for the greater risk that an option may end up “in the money” or at its strike price and exercised. A call option is in the money when the underlying asset’s price rises above the strike price and is “out of the money” when it remains below the strike price. Conversely, a put option is in the money when the underlying asset’s price falls below the strike price and is out of the money when it stays above the strike price. Options are considered “at the money” when the asset’s price aligns with the strike price.
It’s generally most beneficial for options writers to sell an option that expires unexercised, as they retain the underlying asset (if already owned) alongside the premium earned. An exercised option leaves the writer with the premium earned but unable to experience price appreciation of an underlying asset called away when a covered call is exercised. In the case of a put, it leaves the option writer buying an asset below its market value, as in the case of an exercised put.
Premiums rise in periods of volatility to compensate for this added risk to options writers. This, in turn, creates the potential for greater income for options writing strategies during periods of market volatility. For investors comfortable with the risks of options writing, this makes them a potentially attractive choice to use volatility in a portfolio.
Using Options to Hedge Volatility and Drawdowns
Call and put options may be used in a number of ways in strategies seeking a range of different outcomes. Call options are often used in options-based income strategies, where the premiums earned from call writing generate an additional potential source of non-correlated income to the underlying asset. While premiums earned from selling puts also generate income, generally, fewer strategies use them for income purposes.
Instead, investors may seek put options and put option strategies to mitigate risk associated with volatility. A put option can serve as an insurance policy of sorts for an asset. Should the asset’s price fall, the buyer of a put option would only experience a price loss to the strike price of the put. This means that in times of volatility and potential drawdown, owning put options may serve as a hedge against possible price depreciation.
Options strategies may be worth exploring when looking to invest with an eye to volatility. For investors seeking to potentially benefit from expected volatility or hedge against drawdowns and volatility spikes, these strategies can offer enhanced performance beyond traditional stocks and bonds.
Options are not suitable for all investors. Investing in options carries substantial risk and tax consequences. Investors may realize losses on any investments made utilizing leverage. Future returns are not guaranteed, and use of leverage may magnify trading losses.
This article is prepared as a general source of information and is not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. Information contained in this article does not constitute and shall not be deemed to constitute advice, an offer to sell/ purchase or as an invitation or solicitation to do so for any entity. The content of this article is based on sources believed to be reliable, but its accuracy cannot be guaranteed. BMO InvestorLine Inc. and its affiliates, sponsors and employees do not accept responsibility for the content and makes no representation as to the accuracy, completeness or reliability of the content and hereby disclaims any liability with regards to the same. Any strategies discussed, including examples using actual securities, quotes and price data, are strictly for illustrative and educational purposes only and are subject to change without notice. BMO InvestorLine Inc. is not responsible for the information provided and disclaims all liability with regards to the same.
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