By Jon Gold -Principal, Helios LLC
Many of us, particularly those not engaged in financial services, cringe at the words “Derivative” or “Option”. Yet, are you in fact doing your client a disservice by not explaining how these valuable risk management vehicles can be of great benefit to helping them achieve their goals with potentially greater certainty? Even if you are comfortable using the product, the other half of the battle is justifying your clients' trust in you as a fiduciary when you breach the topic.
The first thing to realize is that options abound in your clients’ everyday lives, but many go unrecognized. Put options are more widely understood, since the insurance policies we all buy without a thought are merely put options on our valued assets.
Calls are not as obvious. The popular retail gambit, “30 day price guarantee”, is really a “free” call option on the price of a TV or a set of tires. Other more subtle examples exist. Paying extra for a refundable airline ticket reflecting uncertain travel plans is actually buying a call on that ticket. The option premium is simply the amount in excess of the lower, non–refundable fare.
Calls are perhaps most prevalent in the loan market. A mortgage loan that allows the holder to prepay and refinance at lower rates is really a long call option on interest rates.
Investors may be similarly familiar with selling calls on interest rates, such as investment in a callable bond. In exchange for receiving a higher yield (the call premium, in effect), investors are selling an option to the issuer. If rates fall, the bond issuer will be doing the refinancing at the expense of the investor.
Closer to home, many investors have lately been using options, albeit often unwittingly. Structured products such as principal protected and reverse convertible notes contain embedded options. Perhaps one explanation for their popularity is that advisors can use the risk management characteristics of options without the need to obtain specific option dispensation. That doesn’t mean that the option doesn’t exist – it’s in there! But what price convenience? Creating these products yourself using options affords much more control over the specific parameters, allowing a more tailored fit to your client’s own risk tolerances and financial goals. In an earlier Cboe Advisor eNews, we discussed reverse convertible structures in terms of their stark similarity to cash secured put sales.