Managing Risk with Options

Derivatives like options have been hailed as “weapons of mass destruction” by legendary investor Warren Buffett. Some broker-dealers and registered investment advisors, however, are working to change that perception by educating investors on how options can play a part in an investment strategy, particularly when it comes to managing risk.

At the recent Leveraging Options for Advisors event, hosted by Nasdaq and the Options Industry Council, industry experts spoke to advisors and students from Temple University and Rutgers University about the state of the options industry and how advisors can integrate the asset into investment strategies.

“Everyone is in the mindset of de-risking right now,” said Stacey Gilbert, a portfolio manager on the Derivatives team for Glenmede Investment Management LP (GIM). “Options are, by far, the easiest way to de-risk. If you were to buy a put, it’s the easiest way to explain risk: I bought this insurance, and it will kick in at this level.”

Presently, the market is in the “most unloved bull market that there is,” Gilbert said. A decade into the expansion, recession fears have started to surface amid global growth concerns, recent yield curve inversions, central bank rate cuts, trade uncertainty and political tumult. That said, Gilbert said there is little reason to think a recession is happening tomorrow. In fact, she said that a majority of economists estimate a 35% probability of a recession by next year.

Given the rather roller coaster-like macroenvironment, options present an appealing opportunity for investors, giving the buyer the ability, but not the obligation, to buy or sell an underlying asset or instrument at a specified price before or on a specified date. Put options and call options are at the core of options strategies. The former allows the holder to sell the asset at a stated price, while call options enable the holder to buy the asset at a particular price. Kevin Kennedy, SVP at Nasdaq, says if investors don’t use options to reduce risk and enhance yield, they are leaving money on the table.

“If you had to hedge your position right now, and you had a client that says, ‘I want to hedge, I’m very comfortable with where I’m at,’ I prefer the collars,” said Gilbert, noting that put-spread collars have become quite popular recently. “If I want protection, I want protection on the downside.”

Talking about risk is one of the best ways to introduce options to investors, according to one of the panelists. If someone is not that familiar with options, advisors should use terminology and events to give them a common reference point, noted Nick Rygiel, a financial advisor with Merrill Lynch.

One panelist noted that he typically likes to provide clients with alpha through individual equity portfolios, and then hedge it with beta exposure like the Nasdaq-100 Index (NDX) or Nasdaq-100 Reduce Value Index (NQX). The Nasdaq-100 includes 100 of the largest domestic and international non-financial companies listed on the stock exchange. Nasdaq operates 6 of the 16 options exchanges, representing about 40% of the market, and is home to Dorsey Wright, which was founded as an options firm in 1987, and now provides research, using relative strength and technical analysis to harness momentum in the market.

Irv Rosenzweig, President and CIO at RIA firm RZ Wealth, said he uses the NDX, looking at it from an income perspective.

“People are income-challenged,” Rosenzweig said. “We were using cash-secured puts or put-spreads to look at another income alternative. And, for the non-qualified accounts, having the tax preference of the 1256 contract in the NQX and having the flexibility to the Nasdaq-100 and leveraging that volatility has been important.”

Rygiel thinks that the options area will expand in the coming years, noting that competition is good, but as it grows advisors should incorporate technologies, such as artificial intelligence and machine learning, to adjust their strategies.

“If you’re not using some sort of technology now, then you might want to strongly consider that before you start looking at which strategies that you might implement for your clients,” Rygiel said.

As advisors hone their strategies to fit the current climate, Gilbert suggests looking at more defensive plays.

“There’s the PutWrite Index [and] the BuyWrite Index, these types of strategies offer equity-like returns with probably two-thirds of the standard deviation,” said Gilbert. “Over the long-run, these are strategies that can give you the exposure that you want with that reduced risk that is out there.”

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