If you’re concerned over the state of the world right now, you’re not alone. The global economy is transitioning to unknown territory and the Canadian economy is transitioning along with it.
Markets have held up well so far but retirement investors still need portfolio cushions to ride out the shocks that will come. One way to keep your investments safe while generating solid income is through derivatives like options.
Derivatives derive their value, risk and basic term structure from an underlying asset; normally a stock. Options give investors the right, but not the obligation to buy or sell an underlying asset.
It’s a lot for the average investor to wrap their head around. Derivatives are like insurance policies covering all asset classes including equities, currencies and interest rates. Most are traded by large institutional investors but more retail investors are turning to them in their registered retirement savings plans (RRSP) and tax free savings accounts (TFSA).
For some real-world examples, options-trader Chris Thom from Moat Financial was on BNN Bloomberg this week with three of his latest trades involving Wheaton Precious Metals, TC Energy and Pfizer.
Covered calls as part of a portfolio strategy
A popular option strategy for investors looking for an income stream that dovetails with other income strategies like fixed income, preferred shares and real estate investment trusts (REITs) is writing covered calls on stocks they already own.
The writer, or seller, of a call gives the buyer the legal right – but not the obligation – to buy shares in the underlying stock at a set price (strike price) any time on or before a set date. If the stock rises above the strike price the owner will likely be forced to sell at the strike price but if it remains below the strike price the writer keeps the stock, any dividend it generates and a premium paid by the buyer.
It allows investors to capture two sides of the investment coin: the underlying security and the option.
Investors on the other side of the trade buy call options to protect gains in high-flying stocks, which rewards call sellers (writers) with bigger premiums.
Accessing derivatives through ETFs
The easiest way for most Canadians to access derivatives is through exchange traded funds. Many investment platforms offer a variety of covered call ETFs that span the broader markets or specific sectors like technology or energy.
As an example, one BMO covered call ETF tracks Canadian banks. The current yield on the BMO Covered Call Canadian Banks ETF is 5.8 per cent.
Another kind of derivative ETF tracks the Chicago Board Options Exchange Volatility Index; commonly known as the VIX, or fear gauge. The VIX uses futures contracts on the S&P 500 Index as a real-time gauge of expected price fluctuations over the following thirty days.
VIX ETFs are for retail investors who want to profit from volatility whether stock markets spike up or down, but they could backfire if markets flatline.
Tailor-made derivative strategies
Derivative ETFs tend to be one-size-fits-all and can be difficult to incorporate in an individual portfolio. A qualified advisor can devise a derivative strategy based on an individual’s risk tolerance and return goals.
They are better qualified to determine how much of a hedge is needed, how much protection it provides, how to correlate them with your current assets, and when to take them off.
It’s important to know that not all advisors are qualified to sell derivatives, so be sure to ask.
