Options can be a great tool to complement traditional investing either for hedging and/or directional investing. The flexibility they provide has been embraced by many investors in recent years, as single equity and ETF options activity grew by 173% in Canada over the last decade, ending in 2017. (See Chart 1)
Options can provide higher percentage returns on an investment with a pre-defined maximum loss profile, and multiple options can be paired to provide cost-effective access to target exposure in a specific time frame. Below, we discuss key steps that may help you avoid some of the common errors that may arise from an option trading strategy.
Chart 1: Equity and ETF options grew by 173% in Canada in the last decade
Just as you would for any other investment strategy, you should establish a trading plan for options. Setting specific entry and exit targets can not only help manage the position, but also help structure the most cost-effective trading approach at trade initiation. Time frame and choosing the right expiry are also very important to help ensure an expected event in the stock, such as an earnings release, will be captured by your option strategy.
When investing in options, you should always pay attention to volatility, a critical component in option pricing. When volatility increases, an options value will increase. When volatility decreases, an options value will decrease. It is not sufficient to look at the absolute value of implied volatility to gauge if it is high or low. You should also review the implied volatility included in the option price versus where it has been historically, and how much the stock really moved in the past (realized volatility).
An option may not be cheap even if the volatility looks low. As an example, on March 23, 2018, the implied volatility in Manulife (MFC CN) at-the-money (ATM) options traded at around 18%, 5.5% lower than where it was in early February. But, if you look at historical volatility, the 18% level was still higher than what the stock has realized in the last three months at 14.4%. (See Chart 2)
Alternatively, selling options for yield enhancement because the premium looks high can be misleading. As shown in Chart 3, Well Fargo (WFC US) ATM options, with a two‑month expiry, were trading at 27%, which was close to its highest point in the last year. The stock, however, realized 31% volatility in the two months ending April 6, 2018. If the higher realized volatility pattern persists, an option seller, even at 27% implied volatility, can stand to lose.
Chart 2: Implied and realized volatility in 3-month MFC CN options
Sources : CIBC and Bloomberg, as of March 23, 2018.
Chart 3: Implied and realized volatility in three month WFC CN options
Sources : CIBC and Bloomberg, as of April 13th, 2018.
You should be aware of the opportunity costs of investing in options versus stocks, particularly dividends. An investor holding the stock at record date will be entitled to receive the dividend paid out by the company. A call option holder, on the other hand, will not receive the dividend, but will instead see the option value go lower as the stock price is adjusted to reflect the dividend payment.
You need to know how much stock exposure their options imply. For instance, while trading single stock options in Canada, an investor trading 10 options is getting exposure to 1000 shares. In more detail, if you sell 10 put options with strike price of $50 CAD, you will pay $50,000 CAD if you are put into the stock.
Overall, options, given their flexibility, can be very powerful and complementary tools. For any given strategy, they can protect or enhance portfolio returns in different market environments, but it is very important to educate yourself on the risk and complexities involved in an options trading strategy.
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