They can help investors limit losses or benefit from a recovery in volatile times

Some investors overlook the benefits of options, believing they are too complex. Used wisely, options can help protect, grow or diversify your portfolio – or generate extra income.

Options can be used in all sharemarket conditions and their flexibility is particularly useful now as the coronavirus pandemic causes higher volatility.

In simple terms, options are akin to mini “insurance policies”. How healthier would your portfolio be today if you had taken out insurance on your bank or other shares?

Options are essentially a contract between two parties that gives the buyer the right – but not the obligation – to buy or sell an underlying security at a predetermined price in the future, creating certainty.

Exchange-traded options are available over the 75 largest companies on ASX as well as the S&P/ASX 200 Index, and can be used in several ways. You can use options to:

• Mitigate risks in a falling sharemarket.
• Enhance profit in a rising market.
• Generate income in a flat market.

It is important to understand the features, benefits and risks of options before using them. They provide leverage, which magnifies profits or losses. Ask your financial adviser about whether options are right for you and take advantage of ASX education tools.

The free ASX online Options Course is a good place to start. It has 10 modules, each taking about 20 minutes, and suits investors with some experience of owning shares. ASX also offers an Advancing in Options course for those with options trading experience.

Having completed the introductory or advanced courses, consider the ASX/TradeFloor Options Game. This free, simulated game helps improve your options skills using real-time data. The latest game started on April 27 but you can still enrol.

Here are four ways options could be used now:

(Editor’s note: Do not read the following ideas as investment recommendations. Do further research of your own or talk to your adviser before implementing any strategies below).

1. Limiting losses against further market falls

You have watched the value of your shares fall during COVID-19 and believe the S&P/ASX 200 Index (XJO) could drop further in the next few months as the global economy contracts, and want to protect the value of your portfolio.

An index put option could achieve that. By purchasing XJO put options you can lock in the value of your share portfolio without having to sell stocks.

If your bearish view on the Australian sharemarket proves correct, the profits on your put options will at least partly compensate for the loss of value in stocks in your portfolio.

Learn more about bullish (call) and bearish options strategies here.

Alternatively, you could buy a put option over individual companies if you are concerned that the value of some shares in your portfolio could fall.

2. Making money in a market recovery

What if you believe the market has fallen too far and want to position your portfolio, or shares within it, to benefit from a recovery but minimise the risk if markets were to fall?

You could buy an XJO index call option to benefit from an Australian sharemarket rally. If the S&P/ASX 200 rises, the value of your XJO call options will amplify gains.

Alternatively, you could buy call options over companies on which you have a bullish view and, if correct, enhance gains from those shares.

3. Combining strategies to limit losses and position for gains

As you become more familiar with options, you could combine put and call index/company options to achieve different portfolio goals.

An index put option, for example, could be used to protect your portfolio against further market falls, while call options over individual companies on which you have a bullish view are bought to maximise potential returns.

The strategy could provide the best of both worlds – portfolio insurance against further sharemarket index falls during COVID-19 and exposure to potential gains in your preferred stocks if their price rallies.

4. Managing capital in volatile markets

Another benefit of options is that you only have to outlay a fraction of the share price, through the options contract, for the right to buy that share in the future.

Some investors find they do not have enough available cash to buy preferred indices or shares during bear markets when prices have fallen. They want to avoid selling shares that have dropped in value to free up cash to buy other companies.

An option allows you to outlay a smaller amount to achieve the right – but not the obligation – to buy a security in the future.

Buying a call option is like a layby for shares, as you lock in your purchase price today for a small initial non-refundable deposit. If the market rallies you exercise your right to buy shares, but if the market falls you walk away from the purchase, only losing your deposit.

Next steps

Take the ASX online courses, enrol in the ASX Options Game and talk to your adviser about the benefits and risks of options – and whether they can help achieve your investment goals.

Setting up an account to trade options is no more involved than opening one to buy and sell shares. Call your broker or apply online. Read the ASX explanatory booklet your broker will send you, fill in the necessary forms, make a deposit in your cash management account – you now have the infrastructure to buy and sell options.