Using options to invest in value and growth stocks

Montréal Exchange
October 5, 2022
5 minutes read
Using options to invest in value and growth stocks

Value stocks, as the name implies, offers investors exposure to a company that is valued at a lower price relative to its fundamentals. Growth stocks often refer to small companies that operate in a new market that is likely to experience higher than average growth rates.

Investors may want to seek out a mix of growth and value stocks, or those belonging to one category. Value stocks tend to experience less volatility because the companies are often more established and better positioned for long-term growth and dividend payments. Think companies like BCE Inc (TSE: BCE), Canadian Tire Corp (TSE: CTC), Royal Bank of Canada (TSE: RY).

By contrast, growth stocks are more volatile for several reasons, some examples being: 1) high competition within a new market, 2) inexperienced management team, 3) the market may not grow as fast as previously expected.

Growth industries would include artificial intelligence, big data, electric vehicle charging, metaverse, among others.

There is no set definition of what separates growth from value stocks. Some companies can offer a combination of value and growth. As such, investors should carefully weigh each opportunity to see if it is suitable with their investment strategy.

Adapting your strategy

Investors should also familiarize themselves with options strategies that can be used if an investor selects a portfolio of growth stocks, value stocks, or a mix of both.

Options offer investors an alternative approach that is suitable across all market conditions. A covered call strategy, as an example, can offer some protection against downside risk in high beta stocks.

As a reminder, beta is a measure of a stock’s volatility compared to the broader market (represented by a major index, such as the S&P/TSX Composite Index. A beta of less than 1.0 means a stock is statistically less volatile than the broader market. What this means is if the index loses or gains 5%, we would expect a low beta stock to experience a smaller loss or return.

On the other hand, a beta of more than 1.0 means a stock is statistically more likely to outperform or experience a greater loss than the index. Assuming a similar 5% move in the index, a high beta stock is more likely to gain more than 5% or lose more than 5%.

The cost of doing so is a capped upside gain but this comes with the added benefit of stability.

Buying calls on high beta stocks is another strategy to consider. A long call offers investors exposure to explosive growth while the downside risk is pre-defined, and often lower than buying the stock outright.

Last, options can also be used to gain exposure to value stocks. Since value investors are always on the hunt for a good bargain, options can be used to reduce their cost basis even further. In other words, a good deal on a stock has now gotten better.

For example, assume a stock is trading at $54 per share but a value investor believes it is worth $60 per share. The investor can buy 100 shares for a total cost of $5,400 and expect to profit $600 when shares reach their price target.

Instead, the investor can simply buy a call option with a $54 strike price for a fraction of the cost of buying the stock outright. This offers a similar upside exposure and the added benefit of freeing up capital that can be invested elsewhere at the same time.

Identify your needs

Both growth and value stocks are highly sought after by investors of all shapes and sizes. Recognizing the differences between the two and how each one (or both) can fit into an individual portfolio is the first and perhaps most important step. After identifying the appropriate financial goals and time period, investors should then familiarize themselves with how options can be used to achieve their objectives.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Scroll Up