How options can protect against a portfolio decline

Options are sophisticated financial instruments that can help protect a portfolio from a decline and even provide additional income. Although options are not frequently discussed among regular investors, in fact, they make up of $542 trillion worth of derivatives in the marketplace^1. This tool should only be reserved for investment professionals as it also comes with exceptional risk when not properly utilized.

I was in Japan planning a Shinkansen train trip from Tokyo to Osaka. I was on the way to purchase the full price ticket when I walked passed a ticket trading shop. Walking in, I discovered that you could purchase tickets in advance for a preset price. For example, if I wanted to go to Osaka in March, three months from now, I could buy the ticket now and not take the risk of a higher price in the future. If it turned out that the price was lower at the time of transit, I can return the pre-set ticket for a nominal fee. This is no different than how stock options work. You can buy options to secure your price now and outsource the risk of a price change in the future. If you are afraid of a portfolio decline in the near future, you can purchase a put option which would go up in value if your portfolio dropped.

There are two types of stock options that you can buy: the call and the put option.

Call options go up in value when the underlying investment goes up in value, often at an exponential rate. People buy call options because they're either making a big bet that a particular investment will go up, a lot, and quickly or they're using it as a hedge against other options in their portfolio.

Put options go up in value when the underlying investment goes down. This is a great strategy to insure against a loss in your portfolio. If it turns out that your portfolio doesn't go down or in-fact goes up, the put option that you paid for would just end up being worthless. Like all insurance, there's a cost to having it regardless if it’s used.

Income can be created by selling call options against a concentrated stock position inside your portfolio. You can give the rights to your stock away to other investors in exchange for a fee. People who do this collect income, knowing that if their stock goes up significantly in value they would be forced to sell their stock at the price that the call option was negotiated at. Ideally, your stock doesn't move a lot in value and you can repeat this process by selling more call options, repeating the process, and consistently collect income.

At Eureka Wealth Management, I can help my clients with advanced investment strategies that meet their needs and reduce portfolio risk. I also provide retirement advice, insurance, and tax & estate strategies. Call for a free, initial consultation at (760) 537-0791 or online at eurekawealthmanagement.com.

^1: How big is the derivatives market? - Investopedia.