Businessweek Archives

Weighing Your Options In Options

Where to Invest in 1998 -- Strategies for Stocks: OPTIONS


In the face of violent market swings, a rush to limit risk

Options and futures exchanges are bombarding retail investors with a host of new contracts on stock market indexes. Investors can use them to hedge against the recent stomach-churning volatility of the market or to speculate on its direction. The new arrivals include options and futures on the Dow Jones industrial average, on the E-mini, which is based on the Standard & Poor's 500-stock index, and even options on the Lipper Analytical/Salomon Brothers Mutual Fund Indexes. "More and more investors want to manage their portfolio risk themselves," says Leo Melamed, Chicago Mercantile Exchange chairman emeritus.

Option volume on the U.S. stock options exchanges is increasing. The total number of contracts rose from 199 million in 1991 to 295 million in 1996, and volume is expected to increase this year by almost 20%. The volume of financial futures and options on futures contracts has also risen from 203 million in 1991 to 325 million in 1996 and has already surpassed 350 million so far this year. "Option usage increases with market volatility," says Terry Haggerty, who teaches a course at the Chicago Board Options Exchange for brokers and investors.

THE COLLAR. The option buyer pays a premium and receives the right, but not the obligation, to buy (a call option) or sell (a put option) a stock or a stock index at a specific time for a predetermined price. Contracts usually run up to eight months but can stretch up to three years; these are called long-term equity anticipation securities, or LEAPS. Options can be expensive, depending on the volatility of the underlying securities. The bigger the swings, the greater the risk in owning the underlying stocks, and thus the pricier the option on those securities.

Suppose an investor with a $160,000 portfolio of blue-chip stocks is worried the Dow may plunge--as much as 1,000 points--by March. Buying put options on the Dow is a way to protect that investment. A put on the Dow expiring in March and exercisable at a Dow level of 8000 on Dec. 10 costs $300, plus commissions. Each option represents $8,000 worth of stock-index value, so an investor who wants to fully protect the portfolio must buy 20 puts at a cost of $6,000, plus commissions. If the Dow indeed falls 1,000 points to 7000 by March, each put is worth $1,000 for a total value of $20,000. The 1,000-point, or 12.5%, drop in the market results in a $20,000 loss in the portfolio, assuming it mimics the Dow precisely. The increased value of the puts entirely offsets the loss in the portfolio. But like an insurance policy, the investor pays the fixed cost of the $6,000 premium. If the Dow doesn't fall below 8000, then the puts expire worthless and the investor is out the cost of the puts.

To offset the purchase price of the puts, the investor can employ a strategy that is becoming more and more popular--selling call options on the index at the same time as buying puts. This is known as a collar. The premium for a call on the Dow that expires in March with a strike price of 8000 is $500, minus commissions if the investor is selling the call. The net income from the collar is the difference between selling the call and buying the put. So the investor would pocket $200 for each collar, or a total of $4,000, less commissions. Sounds great. Full protection plus a nice profit. Even if the market stays flat at 8000, the put and call will expire worthless--but the investor still makes $4,000. The big drawback is that if the investor is a worrywart and the market soars, he gives up some big gains.

Mutual-fund investors can also use the new Lipper/Salomon indexes to insure their fund returns against big market dips. The growth index, composed of 30 of the largest mutual funds with similar investment objectives, recently closed at 186.35. One option contract represents $18,635 of mutual-fund value. Say an investor has $160,000 in a growth fund. To protect against swings in the funds' returns, the investor can buy nine puts with a strike price of 185, expiring in March. Each put costs $800, for a total cost of $7,200 plus commissions. If the index falls to 163 by then, each put is worth $2,200 (a 22-point decline in the index times $100). The income from the puts, $19,800, helps offset the roughly $20,000 loss in the mutual fund. Subtract the cost of the insurance policy, $7,200, and the investor makes $12,600 on his nine puts. So he is down $7,400, not $20,000.

LEVERAGE. Bullish investors can buy calls on indexes to limit their investment. The investor buys 20 calls on the Dow that expire in March exercisable at 8000. That represents $160,000 worth of stock. The premium is $500 each, plus commissions, for a total $10,000. To profit, the index must rise above 8500. If the Dow reaches 8800 at expiration, the 20 calls would be worth $16,000. The investor would make $6,000 ($16,000 minus $10,000) on an investment of only $10,000. Of course, he would lose it all if the market closes at 8000 or below. "Index options are a good way to participate in the overall market," says Stewart Winner, director of Prudential Securities' retail options sales and trading.

A variation on simply buying calls is to create what is known as a call spread. The investor buys a call at one strike price, then, to help offset the cost, sells a call at a higher strike price. The investor who bought 20 calls at the 8000 strike expiring in March for $10,000 would, at the same time, sell 20 calls at the 8200 strike expiring in the same month for $7,750, minus commissions. His cost falls from $10,000 to $2,250.

But if the market soars, the investor has capped his upside potential. Suppose the Dow jumps to 8800; then, the 8000 calls are still worth $16,000. But the 8200 calls are worth $12,000 and the investor must pay the call buyer that money. So he ends up with $4,000 rather than $6,000, on a $2,250 investment. If the market were to rocket to 9500, all the investor can make is that same $4,000.

While the total risk of buying options is limited to the cost of the premium, a futures player can lose much more than the original investment. Futures are contracts to buy or sell a specific amount of a commodity, such as oil or a stock index, at a future date at a price specified today. Futures afford investors a lot of leverage. The margin requirement is usually about 5% of the value of the contract. The downside potential can be nearly unlimited if the market moves in the opposite direction. Then, the speculator will keep getting margin calls. If he fails to meet them, his position will be liquidated. Obviously, speculating in futures is risky and not for the average investor.

Far better, futures, like options, can be used as a hedge against a market drop. To hedge $160,000 worth of blue chips, the investor could sell two futures contracts worth $160,000. If the Dow falls from 8000 to 7000, the investor can buy them back for $140,000. That's a $20,000 profit, less commissions, for the two contracts. The $20,000 loss in the stock portfolio would be entirely offset by the $20,000 gain in the value of the futures.

The E-mini S&P 500 futures contract is more useful for investors with broader portfolios that include more than blue chips. It is priced at $50 times the S&P 500 index, or about $48,170 at current levels. To hedge a big chunk of the $160,000 portfolio, the investor would sell three contracts with a value of $145,000.

It has become easier and easier for savvy investors to protect long-term gains without having to sell stocks, or to play the market with only a small investment. If the market continues its violent swings, investors may rest assured the exchanges will keep introducing more options.By Toddi Gutner in New YorkReturn to top

Tim Cook's Reboot
blog comments powered by Disqus