“With premiums much higher this year, it’s a good time to write options,” said Sterling Neblett, a certified financial planner and founding partner of advisory firm Centurion Wealth. “It can be a good strategy in volatile, choppy markets.”
Option-writing strategies range from conservative (covered calls and collars) to extremely risky (naked puts). With the virtually unlimited variations of strike prices and expiration dates available, investors can customize their risk/reward parameters with remarkable precision. For someone worried about the risk of a concentrated stock position, options can reduce their exposure in a tax-efficient way.
“I can dial down beta [market risk] for a client by 50 percent using options without triggering a big tax bill,” said Dave Donnelly, managing director of SpiderRock Advisors. Donnelly’s firm implements option trading strategies for institutional investors to either hedge risk exposures or generate income from a portfolio. He also offers the service to financial advisors who don’t feel capable of managing option positions for their clients.
Most financial advisors suggest that unless you fully understand the risks of buying or selling options and are prepared to manage positions, you should leave it to an expert. It’s not for everyone.
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Ken Nuttall, director of financial planning with Black Diamond Wealth Management, said he uses option-writing strategies — mostly covered call writing — with 15 percent to 20 percent of his clients.
“Our usual strategy is to use options as a way to enhance income from a portfolio,” he said.
Options are powerful tools that carry embedded leverage and far more risk than the underlying securities in the contracts. Premiums are richer now because the risks involved are higher. Buy a call option and it can become near worthless overnight after a bad earnings release. Write one and your potential losses are unlimited if the market surges upward. It’s essential that investors understand what their objective is and how much risk they’re taking with the contracts.
Here are three common option strategies that can generate income and/or limit losses from an investment portfolio.