Hello! My name is Lindsey Ludwig and I am a BlackRock Option Strategist. Today, I want to share three concepts to change how you think about options. First, options as an uncorrelated asset, second, how options can deliver portfolio outcomes and third, their ability to change an existing portfolio or investment as an overlay.
Before we dive in let’s start with defining an option. If you were to search 'What is an option contract?', you’d probably see a definition like this: 'Options are a contract between a buyer and a seller who agree to exchange some asset or underlying investment at a predetermined price at some future date.' As important as definitions are, we are going to move beyond terminology and focus on education that can apply to your portfolio construction process.
Number one, the price of an option fluctuates just like any other security. For example, the price of Apple stock might fluctuate because of future growth potential or earnings expectations. The key difference is the price of an apple option is linked to the stock and fluctuates based on Apple’s stock price, among other factors like volatility or the amount of time left until the contract expires. Some Apple options are designed to go up in price when the value of Apple stock goes up, while other options are designed to do the opposite. Today, we’ll be focusing on this second category of options that help counteract price movement in what an underlying investment or portfolio is doing.
So why would you invest in something that is designed to move in opposition to your assets? If you think about portfolio construction, it has been done time and time again. Low or negatively correlated assets, like fixed income and equities, are commonly used together to reduce overall portfolio risk. Using options to help counteract existing risk is no different.
That leads to our second point. Options can be used to drive certain outcomes. Let’s explore some of those outcomes. They can be used to reduce risk by offsetting losses in your portfolio with gains in the options, creating the potential for a more favorable net result. Like other investments, options may also generate losses, which isn’t necessarily a bad thing. In some cases, option losses can be used as a tax asset, making it easier to tax neutrally transition a portfolio or liquidate low basis holdings. When thinking about using options it's important to consider your clients’ overall objectives and the tradeoffs of each strategy.
The last thing I want you to know is that options can be used on top of your existing holdings, as an overlay. Unlike traditional investments, you don’t have to fund an option strategy with cash, meaning you can keep your asset allocation completely intact. This is commonly referred to as an option overlay, which simply means using options in addition to your underlying portfolio. This applies to your equities and fixed income, whether they be in the form of ETFs, mutual funds, or individual securities. Option overlays allow you to customize outcomes for your clients without needing to touch the underlying portfolio. Like any other investment strategy, options also carry certain risks. They may generate losses, and when does as an overlay, the underlying portfolio and option strategy will behave separately, and may not always perform as expected.
To recap, the price of an option fluctuates just like any other security, they can be used to drive certain outcomes, and can be used on top of your existing holdings.
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