BUSINESSWEEK ONLINE : APRIL 26, 1999 ISSUE
COVER STORY

Why More Investors See Options as a Necessity
Strategies that use them have many goals -- but managing risk is one of the most popular

Profiting from the equity options game is far from child's play. But as the name suggests, options are versatile tools -- and their appeal is growing. Volume on options exchanges, which is split roughly 50-50 between institutional and retail trades, has been increasing steadily over the past six years. This January, a record 35 million contracts changed hands -- a 41% increase over January, 1998, according to the Options Industry Council.

While options can be used to speculate on the direction of stock prices -- allowing investors to put down a small amount of money in hopes of making big gains in a short time -- they are best used to manage risk. The way they trade on the floor of the exchanges needs to be closely regulated, though. If it isn't, big institutions can end up with unfair advantages over the general public . Still, with the Dow Jones industrial average zooming above 10,000 and many Internet stocks doubling or tripling so far in 1999, options strategies could be worth a look.

The stock market has corrected during the summer for the past three years, notes Scott H. Fullman, chief options strategist at Swiss American Securities. "A pause in the rally usually begins in the second quarter, with many of the issues that have led the market to new highs taking a break," he wrote in an Apr. 15 research note.

PROTECTING GAINS. The conventional wisdom for investors worried about risk in the stock market is that they should diversify their holdings more or move some assets to cash. But by buying "put" options -- which increase in value when stocks go down -- you can stay invested in your favorite stocks, participating in the higher returns if the market continues to soar, while protecting your gains on the downside if the market falters. And by not taking profits in the stock, you can avoid paying capital-gains tax. The converse of a put is a "call" option, which increases in value when stocks rise.

The classic way to hedge a diversified stock portfolio using options is to buy puts on the S&P 500 Index. A put gives you the right to sell a contract (100 shares) at a given "strike price" up to a certain expiration date -- usually a couple of months away. When the index goes down, the option to sell at the preset price increases in value, offsetting the loss in your portfolio.

For example, to protect a $130,000 diversified stock portfolio through June, you could buy a put on the S&P 500 Index for $4,400. Once the market goes down 3.4% (the cost of the option as a percentage of your portfolio), you will make $1 on the option for every point the index falls. If the market goes up, the option expires worthless. "You have to realize that to do this on an ongoing basis would be expensive," says Michael Schwartz, chief options strategist at CIBC Oppenheimer.

You can reduce the cost by buying puts that are a little "out of the money," which means the strike price is below the index value, so the first part of the decline isn't hedged. You also pay less for options that last a shorter time. Or you could just hedge part of your portfolio. "I think that to protect a portion of one's portfolio is probably prudent," says Schwartz. "Why risk everything?" Since you can't buy just part of a contract and each S&P 500 option hedges $130,000 worth of stock, options on the S&P 100 index make sense for many individuals, says Fullman. The cost of S&P 100 Index options is about half the S&P 500 options and could be used to hedge a $67,000 portfolio of large-cap stocks.

TOO HIGH A PRICE. Options can also be used to hedge a particular stock, or a sector. Many investors have inquired about how to protect Internet holdings, strategists say. But Schwartz thinks that this is generally too expensive. For example, if you bought a put on The Street.com Internet Index, which includes stocks such as Amazon.com, America Online, Yahoo!, and Excite, it would cost $8,800 to hedge $65,000 worth of Internet stocks. For most investors, that price is too high, Schwartz says.

Options strategies -- often far more complex than the basic ones mentioned here -- can be used to accomplish any number of goals. For example, in his Apr. 15 note, Fullman outlines several strategies using options for clients who own or would like to own America Online (AOL), which he says is "attractive on a fundamental basis" but has a good chance of sliding in price. One strategy, too complicated to describe in detail, involves purchasing half the shares desired at the market price, then selling both calls and puts against the shares.

Clearly, options are a tricky area, and investors should study up if they want to play. The Options Industry Council offers free educational seminars and videos, plus a Web site (www.optionscentral.com) where you can download free educational software and brochures. Fullman credits the exchanges' educational programs with fueling interest in options trading. "There has been a very big learning curve," he says. But there's little choice but to climb it if you hope to avoid getting burned by options.

By Amey Stone

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