By Rudy Aguilera -Principal, Helios LLC
Many advisors view options as speculative securities that are only good for capturing short-term market movements. Truth be told, they are partially correct, as options can be wonderful trading vehicles. However, there is another side to options -- using them to complement your strategic asset allocation. I like to tell clients that there are smart uses of leverage and dumb uses of leverage. We of course, focus on the former. It helps to think of options as fire -- they can warm your house or they can burn it down.
The overwhelming majority of advisors currently use options in one of two ways:
- Protective Puts
- Covered Calls
With a protective put, you are in essence purchasing insurance against a decline. But when is insurance cheapest? When no one thinks they need it. When markets are at all-time highs, investors are not concerned with downside protection. Conversely, when markets are in disarray, investors run for the exits and the cost of insurance skyrockets. This is the scenario we currently face.
With volatility significantly above recent historical levels, many advisors have begun writing calls against traditional equity and ETF holdings. In a covered call, you are willing to forgo some upside appreciation in exchange for a premium, which helps offset any potential decline. The key word is offset, as a significant decline will more than consume any premium you received.