Suitability
In general, suitability test questions on derivatives are few and far between on the Series 66 exam. Although options are not specifically listed in NASAA’s exam outline, we believe it’s possible to see recommendation-based questions involving them. However, there should only be a few test questions, if they show up at all. As we discussed at the beginning of the derivatives section, allocate your time and energy accordingly.
In general, derivatives are not suitable for most investors. How many strategies did we discuss involving unlimited or significant risk? Even if the maximum loss is the premium, that’s still incredibly risky. Regardless, we’ll discuss a few suitable option strategies for conservative and risk-averse investors.
We’ll break down the suitability of derivatives by categorizing them into types of strategies:
- Long options
- Short options
- Hedging strategies
- Income strategies
- Futures & forwards
Long options
When an investor goes long a call or long a put as their sole option strategy, they’re seeking growth (a.k.a. capital gains, appreciation). As a reminder, growth occurs when an investor buys a security at a low price and sells it at a higher price. In many instances, these strategies are referred to as speculative.
Let’s demonstrate how these strategies can result in capital gains:
An investor purchases 3 long XYZ Sep 80 calls at $5 when the market price is $79. The market price rises to $120, the contracts are exercised, and the shares are liquidated in the market.
Can you figure out the overall gain or loss?
Answer = $10,500 gain
| Action | Result |
|---|---|
| Buy calls | -$1,500 ($500 x 3 contracts) |
| Exercise calls | -$24,000 ($80 x 300 shares) |
| Liquidate shares | +$36,000 ($120 x 300 shares) |
| Total | +$10,500 |
The investor went long 3 call options, giving them the right to purchase 300 shares at $80 per share. The cost of each contract was $5 per share. The market price increased to $120, resulting in the options gaining $40 of intrinsic value (in the money). The exercise allowed 300 shares to be purchased at $80. Those shares were then liquidated at the $120 market price, resulting in a $40 per share gain. The $40 gain on the stock is offset by the $5 premium cost, ending with an overall $35 per share gain. $35 gain multiplied by 300 shares results in an overall $10,500 gain.
In the previous example, the investor bet on the market rising (long calls are bullish), and their bet paid off. If the market price stayed below $80, they would’ve lost the total $1,500 premium. Even though the maximum loss for a long option is only the premium, it’s still a very risky venture. Think about it - what if you bought an investment for $1,500 today, and there was a decent possibility you could lose it all within just a few months? When put in that perspective, speculative long call strategies are only suitable for aggressive investors with high risk tolerances.
Let’s now explore how a long put strategy could result in growth:
An investor goes long 2 MNO Feb 110 puts at $3 when the market price is $114. The market price declines to $85, the investor purchases 200 shares at the market price, and exercises the option.
What is the overall gain or loss?
Answer = $4,400 gain
| Action | Result |
|---|---|
| Buy puts | -$600 ($300 x 2 contracts) |
| Buy shares | -$17,000 ($85 x 200 shares) |
| Exercise put | +$22,000 ($110 x 200 shares) |
| Total | +$4,400 |
The investor went long 2 put options, giving them the right to sell 200 shares at $110 per share. The cost of each contract was $3 per share. The market price declined to $85, resulting in the options gaining $25 of intrinsic value (in the money). The investor purchases 200 shares at $85 per share, then exercises their right to sell those shares at $110. The end result is a $25 per share gain. The $25 gain on the stock is offset by the $3 premium cost, ending with an overall $22 per share gain. $22 gain multiplied by 200 shares results in an overall $4,400 gain.
In the previous example, the investor bet on the market declining (long puts are bearish), and their bet paid off. If the market price stayed above $110, they would’ve lost the total $600 premium. Although the maximum loss for a long option is only the premium, it’s still a very risky venture (just like it was with the long call). The prospect of completely losing a premium over a short period of time only is suitable for aggressive investors that are tolerant of risk.
Let’s summarize the suitability of long option strategies:
- Investment objective: speculative growth
- Suitable for: aggressive investors
- Risk tolerance: high
Short options
When an investor goes short a call or short a put as their sole option strategy, they’re seeking income. Similar to long options, these strategies are referred to as speculative. However, these are much riskier investments when they’re uncovered (naked), which is the assumption we’ll make in this section.
When a short option is traded, the investor immediately receives a premium. Investors seeking income obtain their goal immediately when they sell the call or put. That’s the benefit of selling options - instant income.
However, the income comes with a cost - risk. Short naked calls are subject to unlimited risk, while short naked puts are subject to significant risk (equal to the strike price minus the premium, times the number of shares involved). Most income-based strategies involve safer securities like bonds and preferred stock, but that’s not occurring here. Therefore, only the most aggressive investors seeking income that are very tolerant of risk should consider selling uncovered options.
Let’s summarize the suitability of short naked option strategies:
- Investment objective: speculative income
- Suitable for: aggressive investors
- Risk tolerance: very high
Hedging strategies
Unlike the speculative strategies we’ve discussed, hedging strategies aim to reduce the risk of stock options. There are two hedging strategies to be aware of:
- Long stock with long put
- Short stock with long call
While long options can result in losing the premium, these strategies act very similarly to insurance. Extra costs are involved (the premium), but significant stock losses can be minimized. Pairing a long option with a long or short stock position is suitable for investors concerned about experiencing capital losses on their stock. Options don’t last forever (most last 9 months or less), so the cost of paying option premiums over long periods of time can eat away at an investor’s profit potential.
Index options can be used to protect entire portfolios, including mutual funds. For example, a fund manager of a large-cap stock fund could purchase S&P 500 puts to protect against a bear market. If the market declined, the portfolio’s losses would be offset by the returns of the put.
Ultimately, the suitability of a hedging strategy is dependent on the position it covers. While the cost of the premium may reduce profits, it might save the investor from significant losses.
Let’s summarize the suitability of hedging strategies:
- Investment objective: protection
- Suitable for: depends on position it covers
- Risk tolerance: varies
Income strategies
Income strategies involve an investor selling an option against a stock position. There are two income strategies to be aware of:
- Long stock with short call (covered call)
- Short stock with short put (covered put)
Covered calls and covered puts are most suitable for investors with long-term stock outlooks, but expect a short-term flat market. For example, assume an investor owns 100 shares of stock at $75. While they expect the stock price to rise over the next several years, they don’t believe the stock will rise above $80 over the next 9 months. To increase the return on the security, they sell an 80 call against the stock.
The receipt of the premium immediately provides income to the investor. However, it comes at a cost - the investor cannot gain anything additional on the stock if it rises above the strike price ($80 in our example). If the stock price rises significantly above the strike price, the investor faces opportunity cost (risk). This is the primary risk the short call presents to the situation.
Going back to our example, let’s assume the stock price rises to $125. If the investor hadn’t sold the call, they would’ve gained $50 per share. With the short call in place, the investor would be forced to sell the stock at $80, resulting in a $5 per share gain (plus the call premium). This is a good example of opportunity risk.
Missing out on potential return is the only risk the short call presents to the investor, which isn’t a significant risk. In fact, the investor still profits if the call is exercised. Therefore, covered call positions can be recommended to almost all investors who are already long the stock. Obviously, the stock subjects the investor to its own risks (systematic and non-systematic). Regardless, the call actually reduces overall risk for the position by allowing the investor to keep the premium.
To demonstrate this, let’s assume the stock price falls all the way to $0 in our example. The short 80 call is out the money and expires worthless, but the investor keeps the premium. This offsets the overall loss on the stock, essentially “softening the blow” the investor takes from the significant stock loss. If the investor hadn’t sold the call, they would lose $7,500 ($75 x 100 shares). With the short call in place, the $7,500 stock loss will be offset by the premium. If the premium was $400, the overall loss would instead be $7,100.
The sale of a call against a stock position can be recommended to investors of all backgrounds, including older conservative investors. If the investor already owns the stock, the addition of the short call only reduces overall risk (other than opportunity risk).
Let’s summarize the suitability of a covered call:
- Investment objective: income in flat/neutral markets
- Suitable for: virtually all investors if the stock position is suitable
- Risk tolerance: depends on stock position
A covered put, on the other hand, is a very risky position. This is primarily due to the short stock position, which is not protected. For example, let’s assume an investor is short 100 shares at $30 and goes short a 25 put. If the market price stays flat or declines minimally, the investor keeps the option premium and could make gains on the stock down to $25. If the market price falls below $25, the put goes in the money and gets exercised, resulting in the investor being forced to buy back the stock at $25. Similar to a covered call, the short put caps the gain potential of the short stock position.
On the other hand, the investor can lose unlimited amounts of money if the market price rises. The put expires if the market price stays above $25, and the only protection it provides is the premium received. Regardless, the unlimited risk potential is too much risk for the vast majority of investors. Be mindful of how the name of the position - covered put - can be misleading. The put’s risk, which manifests when the market price falls, is offset by the gains of the short stock position. The short stock is the primary risk driver of the strategy.
Let’s summarize the suitability of a covered put:
- Investment objective: income in flat/neutral markets
- Suitable for: aggressive investors
- Risk tolerance: very high
Futures & forwards
As we discussed in the previous chapter, futures and forwards are connected to commodity prices.
Futures contracts are standardized and exchange-traded, allowing any investor interested in commodities to trade these contracts. Similar to options, futures investors can use them to hedge against price fluctuations. For example, Southwest Airlines went long oil futures in the late 1990s and early 2000s to hedge against rising oil prices. Investors can also use futures contracts to speculate (bet) on prices of commodities rising or falling. If their bet is right, they profit (and vice versa).
Forward contracts are customized and non-traded, making them only suitable for those actually planning on buying or selling the commodity. In most circumstances, forwards are used for hedging purposes. Here’s the example we discussed in the previous chapter:
A corn farmer projects their harvest to be 2.5 metric tons and they intend to deliver the corn to a cereal distributor. Both the farmer and the distributor are concerned about price fluctuations. If there’s an oversupply of corn due to favorable weather conditions, it’s possible the price of corn will fall, which would negatively impact the farmer. If there’s a shortage of corn, it’s possible the price of corn will rise, which would negatively impact the distributor.
To hedge themselves against the risk of price fluctuations prior to harvest, the two parties could enter into a forward contract. It would be non-standardized to fit the situation, allowing a custom amount of corn to be delivered at a custom date in the future. By locking in the details of the transaction now, both sides obtain protection against adverse price movements.
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