Recently, many clients have noticed us speaking more and more about the potential need for life and disability insurance. In its simplest form, insurance is a contract offering protection to a possible outcome. So, is there any form of insurance when it comes to a client’s investment portfolio?
The answer is yes, and in this article, we will look at how this is done through a type of investment tool known as a derivative, or more specifically, an option contract. Not only do they protect investments from market volatility, but they also have the potential to earn some income from that same volatility.
How do options work?
One of the oldest forms of option contracts exists within the world of agriculture. A farmer plants his crop in the Spring but cannot bring it to market until harvest time in the Fall. He has no way of knowing with certainty what the price of his crop will be then, so he promises to sell that crop to his future buyer at a fixed price. He gives up his chance to make more if the price is higher in October, but he also protects himself from losing money if the price is lower. Likewise, his buyer locks in his cost at a fixed price and can therefore better predict how much profit he can earn when he turns the crop into a finished product (say, for example, boxes of cereal).
Options in the stock market can work similarly. Broadly speaking there are two types of options: calls and puts.
A call option gives the owner the right, but not the obligation to buy specific securities from a seller within a fixed period at a specific price. For example, if a stock price has risen to $12 and the call contract allows the owner to buy it for $11, she would then “call” the owner of the stock and buy it for the lower price.
A put option allows the owner of the option to force the seller of the option to sell the buyer a security for a higher price than it is currently trading at. Let’s say that the stock’s price has dropped to $22, in this situation the put option forces the owner to sell it for $23.
Why would investors use options?
Like the farmer in our original example, calls and puts act as a kind of “insurance” contract for security owners. The options must be bought and sold, so there is a “premium” cost to buying them, as well as a premium price that is collected by selling them.
Good options traders will use these contracts to protect their portfolios from unusually large short-term swings in the market. They give up some of the upside in a stock price in exchange for protecting their investment from a price drop. They also collect the premium on this insurance by way of selling the call and put contracts, increasing their potential income.
Why doesn’t everyone do this?
First, these options have a price. Not everyone wants to use portfolio insurance products or is willing to pay for this type of protection. Second, option contract writing is complex. Not everyone has the expertise or time, though it could be done on their own it would be nearly impossible. CH Financial has brought in talented fund managers that help us with this strategy. In addition to their complexity, it can also be hard to find someone willing to buy it from them adding another level of risk to the investor.
Who, among CH’s investment partners use them?
We currently use two managers who make extensive use of call and put options: Dynamic Alternative Yield and the BMO Tactical Dividend ETF fund. This is a large part of why they are classified as “alternative” investment strategies. Although retail investors can write their own options, it is almost impossible to do so because they do not have access to institutional investors to engage in an options contract with.
Options are not for all investors nor all investment strategies. For us, at CH we have seen these option strategies benefit our clients’ investment portfolios in the past and they will continue to do so moving forward. We see this as a part of our ongoing responsibility to find ways to reduce risks our clients face, like the life and disability insurance we offer to our clients. If you would like to discuss how this type of insurance within your investment portfolio has been helping to protect your investments, please reach out to us.