DefinitionsOptions are a type of derivative. Now many of you probably have heard stories about derivatives and their role in financial crises, but not all derivatives are created equal. And how you use options, as with any financial instrument, matters. Even though they can be used in a speculative manner, that’s just one of the ways options can be incorporated into an investment strategy. Another is to use options as a hedge in a falling market to limit your downside. That being said, options are complex securities and do come with risks.
As the word derivative implies, options have a value that is derived from something else. For example, equity options are dependent on the price of the underlying stock. They are contracts to buy (a call option) or sell (a put option) the stock at a set price on or before a certain date. Both carry costs (premiums) but also the opportunity to adjust your exposure.
Buyer or seller?Whether you are a buyer or a seller of options can make all the difference in your risk. Buyers (or holders) of calls and puts are not obligated to take action. They get to choose to do so and that helps limit their risk (the maximum loss possible being the premium they paid). On the other hand, sellers (writers) of calls and puts are obligated to take action if required by the buyer. So, they can lose far more than the premium they collected and they have unlimited risk.
PricingWhenever we talk about options, the phrases “in-the-money” and “out-of-the-money” often pop up. What do they mean? It all relates to the price of the stock noted when you bought the option (strike price) and how it compares with today’s price (market price).
If the market price is higher than the strike price, your call options will be in-the-money. This means it would be worth it to exercise your right to buy the stock and profit on the difference between the share and strike prices. When the market price is lower than the strike price, your calls will be less valuable or out-the-money.
The opposite scenario is true for put options. For those to be considered in-the-money, you want the market price to be below the strike price. Then when you exercise your right to sell, you can do so at the higher strike price. If the market price is higher than the strike price, puts are considered out-of-the-money.
Bottom LineKnowing how options work and all the associated terms can help you think about how best to incorporate them into your investment strategy. While speculation may be the most newsworthy, there are multiple ways to use options and they can be a valuable addition to a portfolio when properly implemented.
Potential Parametric Solution
Our Volatility Risk Premium (VRP) Strategies aim to provide a persistent source of return without the use of leverage or market forecasts. They do so by harvesting the VRP, a well-researched phenomenon based on the discrepancy between the implied and realized volatility of equity index options. Parametric has developed a series of sophisticated VRP strategies in an effort to meet different investor objectives.
Tom Lee, CFA - Managing Director - Investment Strategy & Research
Mr. Lee leads the investment team that oversees investment strategies managed in Parametric’s Minneapolis and Westport Centers. In his current position, Tom directs the research efforts that support existing strategies and form the foundation for new strategies. He is also chair of the Investment Committee that has oversight of these strategies. Tom has co-authored articles on topics ranging from liability driven investments to risk parity.
Parametric Portfolio Associates® LLC (“Parametric”), headquartered in Seattle, WA, is a leading global asset management firm, providing investment strategies and customized exposure management to institutions and individual investors around the world. Parametric offers a variety of rules-based, risk-controlled investment strategies, including alpha-seeking equity, alternative and options strategies, as well as implementation services, including customized equity, traditional overlay and centralized portfolio management. Parametric is a majority-owned subsidiary of Eaton Vance Corp. and offers these capabilities through investment centers in Seattle, WA, Minneapolis, MN and Westport, CT.
This information is intended solely to report on investment strategies and opportunities identified by Parametric. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Past performance is not indicative of future results. The views and strategies described may not be suitable for all investors. Investing entails risks and there can be no assurance that Parametric will achieve profits or avoid incurring losses. Parametric does not provide legal, tax and/or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy described herein.
The effectiveness of the option strategy is dependent on a general imbalance of natural buyers over natural sellers of index options. This imbalance could decrease or be eliminated, which could have an adverse effect. A decision as to whether, when and how to use options involves the exercise of skill and judgment, and even a well-conceived and well-executed options program may be adversely affected by market behavior or unexpected events. Successful options strategies may require the anticipation of future movements in securities prices, interest rates and other economic factors. No assurances can be given that the judgments of Parametric in this respect will be correct.
Options are not suitable for all investors and carry additional risks. Investors must ensure that they have read and understood the current options risk disclosure document before entering into any options transactions. In addition, investors should consult with a tax, legal and/or financial advisor prior to contemplating any derivative transactions. The options risk disclosure document can be accessed at the following web address: http://www.optionsclearing.com/about/publications/character-risks.jsp.
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Parametric is located at 1918 8th Avenue, Suite 3100, Seattle, WA 98101. For more information regarding Parametric and its investment strategies, or to request a copy of Parametric’s Form ADV, please contact us at 206.694.5575 or visit our website, www.parametricportfolio.com.