Investors have to find ways of maximizing returns while minimizing risks to get the most out of their investment portfolios. Diversification remains one of the best strategies for doing this. Traditionally, investors have used asset classes like bonds, stocks, commodities, and real estate for diversification.
However, options can also be a valuable addition to a diversified portfolio. In this article, we explore the role options play in a diversified portfolio, their benefits, and how they can help investors achieve their investment and financial goals.
Understanding Options in Investment Portfolios
Options are financial derivatives that grant traders the opportunity to acquire or offload an asset at a predetermined price on or before a specified date. The trader pays a premium to buy the options contract. The predetermined price decided between them and other investors is the strike price, and the predetermined date is known as the expiration date.
The underlying asset used for the contract can be a commodity, currency or currency pair, stocks, bonds, or any other financial instrument.
The two main types of options are call options and put options. When an investor buys a call option, they have the right but not the obligation to buy the underlying asset at the strike price or before the strike date.
If the asset’s price rises higher than the strike price, the investor would buy the asset at a price lower than the prevailing market rate. Such a call option is said to be “in the money” and the investor can buy it and then sell at the higher current market price.
A put option is the opposite because it gives the investor the right to sell an asset at the strike price before or on the expiry date. The investor makes money if the asset’s market value falls below the strike price.
The reason is that they can sell the asset at a price higher than the current market price, pocket the difference and profit.
It is important to understand that all options contracts have standardized specifications. These include the underlying asset, the strike price increments, and the expiration date. Additionally, one option contract represents 100 units of the underlying asset.
The Role of Options in Enhancing Risk Management
Using options for portfolio diversification can improve risk management in various ways. One of these is hedging. An investor can buy put options as insurance against an investment in a specific asset.
If the asset’s value or price falls, they might lose some money selling it, but make money on their put option. The profit they make on the put option can offset some or all of the loss incurred by holding the underlying asset. This is known as the portfolio insurance or put insurance strategy, one of the many option selling techniques that traders and investors can use to protect themselves and their investments.
Additional Income Generation Opportunities
Options have become very appealing recently due to their income-generating power. Traders can buy and sell options to generate income depending on the price movements of the underlying stock’s price. How much they can make depends on their strategies, when they enter or exit certain positions, market sentiment, and volatility.
Traders can also use advanced investment techniques to make their options trades more profitable. For example, they can sell call options against an existing stock option to receive a premium. They can reinvest the premium or use it to reduce the overall cost of the stock while providing a buffer if the price moves further downwards.
Options Let Traders Leverage Market Opportunities
Options allow traders to speculate on the future price of underlying assets. We know that the price of these assets is affected by different events in the financial market. Options can help traders and investors take advantage of any opportunities that arise because they can enter positions to do so fairly easily.
In a bull market where the price of assets is expected to rise, traders can enter into call positions to sell when the market turns or take advantage of the price increase in such a market. They play in a bearish market, where investors expect a downswing in the price and value of assets, and traders can enter put positions.
Remember, put options allow traders to profit when the underlying asset’s price falls below the strike price, which is what investors expect to happen in a bearish market.
Options Can Help Investors Manage Portfolio Volatility
Managing volatility is typically a part of managing inherent risks in investing, but it is different enough that it requires discussion. Every financial market experiences volatility, with the probability of prices fluctuating or swinging rapidly. Prices swing high and low quickly in volatile markets like in cryptocurrency, while they remain within a narrow range in stable or less volatile markets.
Options help traders manage this volatility if they know the correct techniques. Straddle and strangle is considered the best strategy for option buying and selling. Here, the trader buys both put and call options with a similar expiration date. If these options have the same strike price, that is known as straddling, while buying options with different strike prices is known as strangling.
Straddle and strangle is useful if the trader expects huge price swings (high volatility) but does not know which side the price will go. By allowing the trader to take advantage of both up and downswings, this technique can limit losses in case of minor price movements while allowing the trader to benefit from large price swings.
Combining Options with Traditional Assets
You can combine assets with any other investment vehicle when diversifying a portfolio. One thing to understand is the weighing of the assets so included. Every asset class should have the same value regardless of the price of an individual part. For example, if you have 1000 shares with $5 each, you should have a real-estate holding worth $5000 to balance things out.
Talk to your financial advisor so they can show you how to balance and rebalance your portfolio for the best returns and additional benefits.
Although they have become popular in recent years, many investors are still not leveraging options when diversifying their portfolios. Options are an excellent addition to any investment mix, providing benefits such as helping hedge against inflation, reducing risk, and opening up new avenues for income generation.