Stock Market Volatility And Flat Returns Challenge Options Investors

Option contracts expire worthless if the market does not move up or down consistently

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Stock option buyers have had a tough time over the past few months. A novice options buyer would find this scenario especially challenging since, despite the volatile market, there was no sustained movement up or down.

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The market cannot trade sideways forever for options investors wishing to make a good profit. Due to the fact that options give the owner an option not to buy or sell a security at a predetermined price within a specific time frame, it can be a stock or exchange-traded fund. The stock or ETF option contract expires worthless if the stock or ETF moves insufficiently in the desired direction.

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Bob Lang, the chief options strategist at financial company Explosive Options in Boston, says trading options is difficult due to timing issues. "You have to make the right move at the right time in order to profit."

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A lack of direction

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The market hasn't had a real direction for more than half a year, which is unfortunate for options investors. A high of 4300 and a low of 3575 have been the highs and lows of the S&P 500 index of large-cap stocks since mid-August. Similar performance was seen in SPDR S&P 500 (SPY), an exchange-traded fund that tracks the S&P 500.

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As the price chart for a market index looks during such periods, Wall Street professionals call it a sideways market.

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In recent months, high market volatility has boosted option prices on average, making things worse for investors. As volatility in the market changes, so do the costs of options on the S&P 500.

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Because the market has been going nowhere for months on end and options are expensive, many investors have steadily lost money on their expensive options. Mr. Lang warns investors that they would have lost money if they had purchased long-dated options.

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Since effective options trading requires significant knowledge, Independent Advisor Alliance's chief investment officer Chris Zaccarelli does not encourage amateurs to trade.

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He says that sideways markets present options and challenges. "Time usually runs out before you get to reap the benefit of your investment."

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Plans that don't work

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Financial professionals such as Mr. Zaccarelli say that it is possible to make money even when the market is in a rut.

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During a sideways market, covered calls can be sold well, says Mr. Zaccarelli. A call option is written on shares that you already own that are out-of-the-money. If the stock or ETF rises to a certain level before the expiration date, you sell the right for someone to buy it. The seller keeps the premium from the option sale if the stock does not rally above the strike price.

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Mr. Zaccarelli describes it as "double dipping.". When an investor sells an option, they receive an option premium plus a dividend, or if they own a stock that has no dividends, the option sale results in a dividend.

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Investors should be aware that selling covered call options has the drawback of capping their potential profits if the market rallies sharply.

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As a result of Mr. Lang's suggestion, sideways markets aren't the only situation that can be dealt with. Many people who do not understand how to use put options [which allow you to sell your shares at a predetermined price for a limited period] never use them. If a stock or ETF's price falls below a certain threshold, the put option pays out. If the current price of XYZ is $100, an investor may purchase put options at $80 a share on shares he already owns. If the option contract remains valid, the investor will not lose more than $20.

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The purchase of put options can be compared to purchasing an insurance policy for your portfolio. In order to avoid a financial disaster, Mr. Lang recommends purchasing health, home, and life insurance. Markets tend to trend upward over time, he admits. Consequently, put options are often worthless when they expire. Therefore, there is a cost involved.

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There are two distinct advantages to putting options, however. In times of market turmoil, they do contribute to reducing losses. Reduced risk is also associated with lower portfolio volatility.

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Lang says he can see opportunities when stocks fall and he has options protection.

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