Morningstar Advisor - Winter 2008 - (Page 22) Gray Matters Learning to Fly with Equity Options By Philip Guziec Master these powerful tools, and the sky’s the limit in terms of portfolio management. Are equity options appropriate for individual investors? Options are powerful but complicated tools. Like all tools, however, skillful use can create tremendous value. In the case of options, skillful use can control the risk exposure and timing of returns of individual investments or a portfolio to meet an investor’s needs. To build the necessary skills to add value to a portfolio through options, advisors and investors need to develop an intuition about the unique characteristics of options. The textbook definition of an option is the right, but not the obligation, to buy or sell a given security at a given price. I prefer to think more intuitively about options as tools that allow an investor to buy or sell just the upside or downside of an investment relative to a predetermined value, thus bounding the risks and in exchange for cash flow today. To bolster this intuition, it can be helpful to consider the risk breakdown between stocks and bonds. Investors tailor their risk and return preferences by purchasing a mix of stocks and bonds. In this way, the typical individual investor’s portfolio is already full of options. Purchasing a common stock is simply purchasing a call option on the value of a business. The stockholder gets the right to the uncertain cash flows of the value of the company above the value of the debt. If the company goes bankrupt, the stockholder owes nothing, and the bondholder takes any loss in the value of the company below the face value of the debt. If the company grows in value, the bondholder captures none of the upside above the value of the bonds and the stockholder captures all of the upside to the value of the company. So, just as dividing a company’s capital structure into stocks and bonds allows investors to tailor their risk exposure, dividing a stock return into chunks with bounded outcomes allows investors to further tune their risk exposure to meet their tolerance. How can the use of options bound outcomes and cash flows? Equity and index options allow investors to manage the timing of their cash flows, because they have a finite time horizon. By using options over that time horizon, investors can Managing Risk/Return and Cash Flow 5% 5% 5% $ Graph A: If investors sell all of the upside to an investment to buy downside protection, they earn a riskless return. 22 Morningstar Advisor Winter 2008 Graph B: Investors can sell some upside to buy downside protection, bounding their returns. Graph C: By selling some of the upside, investors can pocket cash today.
For optimal viewing of this digital publication, please enable JavaScript and then refresh the page. If you would like to try to load the digital publication without using Flash Player detection, please click here.