Understanding How Options Work, Why They Matter, and How Investors Can Use Options
An option is a contract that gives you the right—but not the obligation—to buy or sell a specified amount of an underlying security—like a stock or ETF—at a specified price (the strike price) before a certain date (the expiration date). There are two basic types:
Options can be used in multiple ways—using either calls or puts, or in various combinations—to seek various investment objectives, such as generating income, hedging to mitigate risk, or speculation.
Why Options Are Growing in Popularity?
For decades, investors have relied on traditional securities for growth and income, while relying on diversification as their primary form of risk mitigation. However, since the Great Financial Crisis of 2007-09 (“GFC”), significant declines in interest rates and the convergence of asset correlations have redefined the investing landscape.
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Let’s dive into each of these reasons a little further:
First, the interest rate environment affects where investors seek income.
The long-term secular bull market in the 10-year U.S treasury yields has ended and it appears the cycle has shifted towards higher rates in a world awash in debt.
Source: Source: Swan Global Investments, LLC, St. Louis Federal Reserve, Organization for Economic Co-operation and Development (OECD), Shiller, www.econ.yale.edu/~shiller/data.htm: 10-year U.S. Treasuries 1926-2021. The 60/40 portfolio refers to 60% Ibbotson US Large Stock Inflation Adjusted Total Return and 40% Ibbotson US IT Government Inflation Adjusted Total Return USD.
This creates a bit of a trap for investors seeking income. While higher interest rates seem intriguing for income investors, a prolonged, upward trend in rates threatens capital losses.
So investors seeking yield may continue to look to income alternatives, like dividend-paying stocks, REITs, MLPs, and options-based strategies, referred to as derivative income strategies. Derivative income strategies may pose lower duration risk than other alternatives, meaning less sensitivity to changes in interest rates.
Second, risk management has become more complicated after the Great Financial Crisis as well.
The convergence of asset classes has left investors looking for other ways to mitigate portfolio risk. The matrix below shows the correlations, or how assets move in relation to one another, of different assets since the Global Financial Crisis of 2007-09. In this matrix, a value of 1.0 means the two associated assets (row and column) move in the same proportion and in the same direction. Red and green hues are used to show high and low correlations, respectively.
The correlations between asset classes are much higher than they were previously. See our post on the correlation conundrum for a deeper discussion.
Asset Correlation Matrix
Source: Zephyr StyleADVISOR, Swan Global Investments
Faced with this new reality, investors are seeking new options.
Options and options-based strategies offer investors myriad ways to seek growth of capital, income, and risk mitigation. As such, options and options-based products have seen an explosion in popularity.
Why Swan Uses Options
At Swan, we view options as fundamental investment tools. As an innovative asset manager specializing in options strategies, we’ve been helping investors navigate uncertainty to achieve their long-term goals since 1997.
Our founder, Randy Swan, identified problems with assuming that historical correlations will remain consistent, especially during market crises. Thus, he pursued the use of options to directly mitigate risk and seek income generation.
1. Income Generation
Derivative income, also called options income, can be generated by the sale of an options contract. Writing (selling) call options on existing stock holdings or a stock index—known as covered calls—can produce regular income from the premium collected via the sale of the call options.
2. Hedging Downside Risk
Buying put options may provide downside protection. For example, hedged equity is an investment approach that pairs equity investing with put options to define risk—offering a layer of downside risk mitigation while maintaining equity exposure.
3. Structured or Defined Outcomes
Strategies like zero-cost collars or put spread collars combine puts and calls to define both upside potential and downside risk in advance.
While options bring flexibility, they also carry important risks to consider:
Read more about the risks in options strategies here.
Derivative or options income strategies or funds can be utilized:
Hedged equity strategies or funds can serve different roles in a portfolio, based on investor objectives, such as:
For investors with concentrated holdings or nuanced risk needs within a portfolio, custom option overlay strategies providing bespoke hedging and income solutions might be appropriate.
Final Thoughts
Options offer investors practical ways to generate portfolio income, define and hedge risk, and seek growth of capital.
At Swan Global Investments, we’ve been innovating and refining option-based strategies since 1997. We welcome the growth in popularity and use of options and options-based strategies. Whether through ETFs, mutual funds, or tailored SMAs and custom overlays, our goal is to help investors grow and preserve wealth.
Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms.
All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. All data used herein; including the statistical information, verification and performance reports are available upon request. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. Further information is available upon request by contacting the company directly at 970-382-8901 or www.swanglobalinvestments.com. 094-SGI-052825
