Greater Investment Strategies: You’ve Got Options

By Jordan Waldrep, CFA , Bank OZK Chief Investment Officer, Trust & Wealth

“Options” are a financial tool that can be scary for investors. The mainstream media often portrays them as tools for illegal insider trading or reports on them when some fortunate Reddit user happens to hit it big. Here’s the reality: options can be as risky or as safe as you want them to be.?In the hands of a skilled professional, they can be used to reduce risk or modify the possible outcomes of an uncertain market.

What’s an Option?

An option is a contract that gives you the right, but not the obligation, to buy or sell a stock at a specific price (called the Strike Price) before a certain expiration date. There are two main types of options:

• Call options give you the right to buy an asset at a set price. Since you have the right to buy at a fixed price, when you own a call option, you make money when the price of a stock rises.
• Put options give you the right to sell an asset at a set price. When you own a put option, you have the right to sell at a fixed price, so you make money if the stock price falls.

You can buy or sell multiple puts or calls to create many diverse and desirable outcomes. Some strategies have unique sounding names like an “Iron Condor” or a “Christmas Tree,” but those specific strategies aren’t what we’re looking at today. In today’s market, we’re looking for strategies that can help investors reduce the risk or boost the return of their portfolios.

How Options Can Reduce Risk

Here, I’ll highlight a few simple strategies that use options to reduce risk. These tactics either limit the amount you can lose on your investment or provide insurance against movements.

1. Protective Put

A protective put is like buying insurance. Remember, when you purchase a put option, that gives you the right to sell your stock at a specific price if its value drops. If we buy a put for a stock that you own, you’re protected if the stock falls. Let’s say you own a stock worth $100, and you buy a put option with a strike price of $90. If the stock’s value drops to $80, you can still sell it for $90. This strategy limits your losses to $10 per share, plus the cost of the option, no matter how low the stock’s price goes.

You may be wondering: Why would someone pay for insurance like this? Imagine that you have a stock with a large short-term gain. A protective put may give you peace of mind while you wait for your stock to hit the long-term capital gains rate.

2. Covered Call

A covered call strategy is a way to boost income in your investment. For a covered call, you sell a call option for stock you own. Essentially, if the stock price goes up to a certain level (the strike price), you’ll have to sell it at that price. In exchange, you get paid a premium from the buyer of the call option.

Using this strategy is a trade-off for investors. On one hand, you forgo the upside of owning a stock above the strike price; however, you gain income from selling the call option. That extra income can be valuable to buy and hold investments and offset potential losses if the stock price falls.

3. Collar Strategy

A collar strategy is a combination of the protective put and covered call. You buy a put option to protect against large losses on the downside. Simultaneously, you sell a call option to pay for that insurance and potentially earn some extra income.

The collar strategy is an effective way to reduce the cost of downside insurance.

Benefits & Drawbacks

When it’s all said and done, leveraging options for risk management gives you a way to protect your investments without selling them. This can be beneficial for investors if selling an asset would trigger taxes or if they just want to earn more from their investments. However, as we all know, there’s no such thing as a free lunch. There’s a cost to using options. When you buy them, you also pay a premium, and options expire, so it’s critical to stay aware of when your strategy disappears.?

To Sum Up…

Options are useful tools for managing risk in an investment portfolio. Strategies like protective puts, covered calls, and collars can help limit losses or protect investors from sudden market movements. While options come with costs and require some expertise, using them wisely can provide peace of mind by mitigating potential risks in your investments.

Need help with your investment strategy or just want to learn more? Connect with us today: Trust & Wealth | Bank OZK. Bank OZK’s local financial experts are here to help you open the door to greater possibilities.

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