Turning to Derivatives for Safety?

Among the many lessons the market has reinforced over the past few years is that a badly shaken nest egg is often a broken nest egg. So it’s no wonder that since 2008, investors have rolled hundreds of billions of dollars into commodities, bonds, smaller stocks, foreign stocks and a slew of other assets in the hopes of minimizing the up-and-down swings of their portfolios.

But guess what — most of these efforts haven’t worked. For about a year, nearly every asset class has been moving in the same direction at the same time; when one thing has moved up, almost everything else has gone up too. And in the spring, when debt worries and data suggesting a slow, sluggish economic recovery sent stocks down, they took nearly everything else with them. Now, with a push from the financial industry, individuals are finding a new way to roll the dice: derivatives. Some of these financial products have gotten some bad press, certainly; a few Byzantine versions of derivatives helped exacerbate the financial crisis. Indeed, Warren Buffett calls some of them “time bombs.” But simple derivatives, known as options, can be a good tool for many investors, experts say. “Used the right way, they can help either protect a portfolio, add extra income or both,” says Nicholas LaVerghetta, a financial planner at NCM Capital Management, in Ramsey, N.J., who has lately boosted his use of options for clients.


In use for decades, options are pieces of paper giving someone the right to buy or sell a stock at a certain price on a certain date. Many professional investors use them either as insurance or, conversely, as a high-risk, potentially high-return way to invest in a particular stock. For all these reasons, options are gaining in popularity. At TD Ameritrade, 26 percent of the trades involve options, up from 19 percent two years ago. Charles Schwab says its options training sessions are regularly filled to capacity, and the firm recently agreed to buy optionsXpress, an online brokerage loved by derivatives traders, for $1 billion. Meanwhile, investors who don’t want to buy options themselves are jumping into mutual funds that use them; funds that use an options-based strategy now have $12 billion in assets, up 40 percent over the past year, according to fund researcher Lipper. More than a third of such funds, in fact, have launched in the past 18 months.

Investors, however, are finding there’s a difference between using options and using them effectively. In fact, a March study coauthored by Gjergji Cici, assistant professor of finance at The College of William & Mary business school, found that options users had an annual average return of two to three percentage points less than nonusers. That’s a big reason many financial advisers stick with simple options strategies aimed at mitigating risk through hedging rather than going for a home-run return. One popular strategy, especially when the market is flat or falling slightly, involves writing covered calls — essentially, selling an option on a stock an investor already owns. Here, the investor sells an option, giving someone else the right to own the stock if it reaches a set higher price by a certain date (usually one or two months in the future). In return, the investor collects a premium. If the stock doesn’t reach the agreed-on price (the “strike price”) by the set date, the investor keeps the stock — as well as the premium. If the stock falls in the interim, the option expires and becomes worthless, but the investor still gets to keep the premium, which offsets some of the stock’s lost value. If the stock soars beyond the strike price, the investor keeps the premium but coughs up the shares, leaving the investor with that modest preset upside and likely some seller’s remorse.

Some mutual funds, such as the Neiman Large Cap Value fund, aim to juice their generated income by selling covered calls on dividend-paying stocks — for example, the fund’s investors collect the dividend and then the extra income from selling the right to own the stock. “It’s mostly for people who don’t want to be all in the stock market but want a bit more return on the stocks they own,” says Samuel Scott, president of Leawood, Kan. based financial-advisory firm Sunrise Advisors, who has started to use the strategy again for clients in the past few months.

For investors who want even more protection, some advisers opt for a “collar.” This more complicated strategy involves selling a covered call and using the proceeds to buy a put — or the right to sell the stock at a set price, usually lower than the amount at which the stock is currently trading. The put is insurance against a market tumble and, advisers say, is best used in a market that occasionally stumbles, not one that soars and collapses. This strategy will cost investors up front since the puts are typically more expensive than calls, says Steve Quirk, senior vice president of TD Ameritrade’s Trader Group. Several funds often use puts or calls on the S&P 500 index to try to minimize losses, but only when the puts are relatively cheap. To be sure, advisers say it could be better just to sell stocks and avoid options entirely if the market gets exceptionally volatile and everyone is scrambling to buy insurance. Nevertheless, some pros say the peace of mind and ability to keep investors in the market is worth the insurance price. “People are more hesitant to buy protection on a $30,000 stock position than a $30,000 car, even though the likelihood of a decline in the market is probably greater than running into a tree,” says Randy Frederick, director of trading and derivatives at Schwab.

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