Market Volatility and Options 101

Volatility can strike a stock market with no advance warning, and the average investor might not know how to react. Fortunately, all it takes is some basic knowledge of options to understand how this valuable investment tool can be used to ride through a volatile period.

Potential Sources of Volatility 

Factors that could contribute to market volatility include:

• Unexpected decisions by the central bank,
• New taxes or regulations that will affect corporate profits,
• A global disruption to economic growth, such as that caused by the COVID-19 pandemic,
• Multiple corporate giants reporting disappointing earnings at the same time,
• Announcements of GDP or employment data that miss expectations.

Once panic turns into rampant fear, stocks could be in for a period of sustained downward momentum, with no immediate signs of when or if a rebound will occur.

Options Protect Against Volatility

Young investors who are several decades from retirement may not be as concerned about near-term stock market volatility. After all, a 25 year-old young adult starting a career has at least 35 years to save and invest for retirement.

But individuals who have already retired or who are close to retiring may not be in such a fortunate position. Someone who is 64 and counting down the number of months until their retirement would likely lose sleep at the prospect of their savings dwindling away once volatility suddenly enters the market.

Savvy investors with a game plan can sleep comfortably knowing that their retirement fund is secure if they use options.

In our example, the 64 year-old investor who can’t afford to lose a large portion of his or her savings can use put options to protect a portfolio. As you may recall, a put option gives an investor the right (but not the obligation) to sell a stock at a certain price on or before a set date.

If the investor has 10 holdings in his portfolio, buying put options for each stock would be the logical move, unless the stocks are in defensive sectors that perform well during times of uncertainty.

The prospect of buying 10 different put options may not appear affordable, but it will ensure that even larger losses will not be incurred. Perhaps even more important, put options can help individuals sleep at night, knowing that their life savings are secure.

Options Can Generate Huge Gains During Periods of Volatility

Buying call and put options as a strategy to generate profit (rather than as a hedge against downside) could generate substantial returns for investors. A savvy investor who picks up on clues of a pending market selloff could make profitable use of put options.

Suppose that an investor is paying attention to a central bank presentation and notes that the tone and choice of the words used by the Governor are a lot less positive than they were a few months ago. At nearly the same time, a major multinational bank reports a highly unusual earnings miss, citing consumer weakness.

Taken together, these clues suggest to the investor that an era of economic expansion has come to an end. The investor can then buy put options on the stocks that he or she believes will be hardest hit, such as stocks in the financial services and technology sectors.

Conclusion: Understand How Options Are Used

Options are designed to be used by investors either to protect their stocks from a downside slump or to profit from volatility. Investors should take all the time they need to understand the risks and how options can be used in their investment strategies.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2021 Bourse de Montréal Inc. All rights reserved.  Do not copy, distribute, sell or modify this document without Bourse de Montréal Inc.’s prior written consent. This information is provided for information purposes only.  The views, opinions and advice provided in this article reflect those of the individual author.  Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this publication, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information. This publication is not intended to provide legal, accounting, tax, investment, financial, or other advice and should not be relied upon for such advice. The information provided is not an invitation to purchase securities listed on Montreal Exchange, Toronto Stock Exchange, and/or TSX Venture Exchange. TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.  Montréal Exchange and MX  are the trademarks of Bourse de Montréal Inc.  TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license.