Options are powerful financial instruments that offer investors flexibility, risk management, and strategic opportunities in portfolio management. When used correctly, they may potentially enhance returns, hedge against losses, and provide a more dynamic and diversified approach to investing. This article explores the role of options in portfolio management.
Portfolio management involves strategically selecting and managing a mix of investments to achieve specific financial goals. When trading options, portfolio management can be classed as a mix of active and speculative management as it combines elements of the two styles.
Active portfolio management
• Seeks to outperform the market by actively buying and selling securities.
• Investors or traders use research, analysis, and market timing to make investment decisions.
• Common in mutual funds, hedge funds, and discretionary managed portfolios.
• Adjusting stock holdings based on market trends and economic indicators.
Speculative portfolio management
• Involves high-risk, high-reward investments such as options, futures, cryptocurrencies, and penny stocks.
• Requires deep market knowledge and risk tolerance.
• Day trading volatile stocks or investing in early-stage startups.
Options trading can be used in various ways to help optimise portfolio performance, reduce risk, or generate income. Our previous articles outlined and explained strategies that provided the investor with solutions and tools used to potentially maximise their investments.
Why diversification is important
Diversification in investing is important to manage the volatility of the stock market. Putting all your eggs in one basket could potentially expose your portfolio to stagnant investments, heavy losses and investments with no real returns.
Having a portfolio with multiple securities such as stocks, ETFs, bonds, cryptocurrency and options allows for greater exposure to the market and the potential to increase passive income. The percentage split in a portfolio's diversification is entirely up to the investor and their risk adversity. Some investors may not feel the need to diversify through particular securities, again this plays into their risk adversity.
Benefits of using options trading in portfolio management
In portfolio management, options are primarily used as a tool for risk management, allowing investors to hedge against potential losses in their portfolio by purchasing put options and potentially creating a safety net against adverse price movement in the underlying assets, while still maintaining the potential for upside gains. This strategy can be particularly valuable during periods of market uncertainty or when an investor wants to protect specific holdings within their portfolio.
Hedging against market volatility
Options can serve as a method against market downturns. For instance, buying put options on a stock or index can help protect against losses in a declining market.
Generating income
Writing (selling) options, such as covered calls, may help to generate income for investors holding stocks. This strategy allows portfolio managers to earn premiums while maintaining stock ownership.
Enhancing returns
Options provide leverage, allowing investors to control larger positions with a smaller initial investment. While this increases potential returns, it also amplifies risk.
Strategic flexibility
Investors can use various strategies to capitalise on market movements, including bullish, bearish, and neutral positions, depending on their outlook. E.g. buy calls allowing upside opportunity without owning stock.
Diversification
By trading in options investors can diversify their portfolios further whilst also expanding their opportunities. The purpose of diversification is that you don't put "all your eggs in one basket" and include securities such as stocks, ETFs, options, bonds and the like depending on your investment goals. Adding options to the mix is a strategy used by investors as an option is a type of derivative financial instrument because its value is derived from an underlying asset (e.g., a stock or an index). By adding other securities to your portfolio, you theoretically reduce risk.
Incorporating options into portfolio management may potentially provide significant benefits, including reducing risk, income generation, and strategic flexibility. However, investors must understand the complexities, risks, and potential pitfalls of these instruments. Whether using options to hedge a portfolio, enhance returns, or take advantage of market volatility, a disciplined and well-informed approach is essential for success.
Visit our Options Trading page on the website to explore more opportunities. Join Tiger Trade and practice options trading with no real capital risk by using the Tiger Trade demo account. Plus, if you open an account, you'll get four $0 brokerage monthly trades on either ASX, US stock, ETFs or US options.*
*New clients & unfunded existing clients only. Only min. brokerage waived for 4 ASX, US stocks or ETFs or options trades. Third-party fees and other fees still apply. See T&Cs for details.
Capital at risk. Options trading carries a high level of risk and may not be suitable for all investors. You should only trade with money you can afford to lose. See FSG, PDS, TMD and T&Cs via our website before trading. Information provided may contain general advice without taking into account your objectives, financial situations or needs. Past performance is no guarantee of future results. Graphics and charts are for illustrative purposes only. Tiger Brokers (AU) Pty Limited. ABN 12 007 268 386 AFSL 300767
