Blogs & Comment

Options give you, well, choices

Forget what you think you know about risk—there's a trade for every market.

(Photo: Oliver Cleve/Getty)

It’s true: I love options. With options, there is always something you can do. If the market is choppy, there’s an options trade for that; if it’s trending down, up, or flat, there’s an options trade for that too.

The existence of calls and puts on quality listed stocks also adds to market completeness (which I recently wrote about in “Market completeness and ETFs“), and thereby is a general benefit to all investors; options also provide the ability to make excess positive rates of return, which is to say: to improve the risk-reward ratio of an equity-only position.

I’ll give you an example of the latter, by way of a question. What do you think is more risky: holding 1,000 shares of BCE Inc. (TSX: BCE) (trading at about $38.60 at the time of this writing) in your RRSP, or holding 1,000 shares of BCE Inc. in your RRSP alongside 10 at-the-money puts on BCE Inc.?

There are, of course, investors who believe that trading options in whatever form, but especially with your retirement nest egg, is inherently risky because they word-associate the word ‘options’ with ‘risk.’ But that isn’t universally true. Yes, some options positions are very risky—so risky that I will never employ such strategies. But there are others, such as covered call writes and protective puts, that can actually be less risky than an outright stock position, if done correctly.

Getting back to the question/example above, with a long-only position of 1,000 shares in BCE, the investor could potentially lose around $38,600 of his or her retirement money at current prices, if BCE went to zero. Not that that’s likely, but it could happen. By contrast, with the long position plus put options, that loss could be trimmed to perhaps $2,000 (put purchase costs and commissions) at the most.

So there you have it: without the puts you could lose $38,600; with the puts you could lose $2,000. The potential upside return for both positions is basically identical. Advantage: the strategy involving the puts.

To be crystal clear, this is not to say that all who hold BCE in their RRSPs should rush out and buy puts on those positions. This is to plea that you give options a fair shake when you consider using them, especially in employing a covered write, a protective put, a long call or maybe on occasion a long put. To say ‘all options are risky’ is the same as saying ‘all real estate is risky’ when there’s a world of difference between buying a house, living in it and paying it off over 25 years; and trying to quickly flip properties in an attempt to double or triple the small down payment made.

Even for those who decide to never buy or sell options, near-term options prices can be a useful guide for timing large equity purchases. It’s well understood that short-term call option prices get inflated as investors generally get more optimistic about near-term market trends, and vice-versa. Short-term put options increase in value as fear about the near-term market increases, and vice-versa. The put-call ratio measures whether short-expiry calls are currently expensive relative to puts, or whether puts are relatively expensive to calls right now.

A new member to this group is theS&P/TSX 60 VIX index, which essentially measures whether both puts and calls are expensive right now (an indication of an expected increase in market volatility) or whether both are cheap right now (a possible reduction in volatility relative to recent times).

This indicator only has a chart going back a year and a half or so, but that gives us an idea of how tight the range is. If the VIX is over 20, or even 19, it’s considered very high, and if it’s below 14, it’s considered low. Today it’s at 14.41, so it’s currently at the low end of the normal range.

That’s a good sign, one that the market is not expected to show a lot of volatility, at least in the next month. There’s an option trade for that, too.