Building Exposure into Your Portfolio with Options

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Stock options are simply the right to buy or sell an asset at a specific price and time in the future. Often times, international investors will use stock options to hedge their portfolios against declines using protective puts. These strategies can be very useful, but stock options can also be used to build international exposure into a portfolio either over the short-term or long-term.

In this article, we’ll take a look at how to use stock options to increase exposure to foreign markets without the upfront costs of actually purchasing assets.

Strategies for Long-term Investors

Most stock options strategies are designed for short-term traders, particular when using call options rather than protective put options, since they are short-term in nature rather than long-term. Fortunately, Long-term Equity AnticiPation Securities (“LEAPS”) provide a great alternative for long-term investors, with expiratory cycles measured in years rather than months like traditional options.

LEAPS call options can be used as a substitute for stock ownership in some cases, as well as a long-term protective put option. For example, suppose that an international investor would like to bet on a recovery in China but is hesitant to commit a substantial amount of capital to the position.

Price for 100 shares: $3,500

35.00 JAN ’16 LEAP: $4.40

Price for 100 contracts: $440

In this case, the international investor would be able to purchase the right to buy 100 shares at $35.00 a piece for $440 instead of buying 100 shares at a price of $35.00 a piece for $3,500. The breakeven point for the trade would be approximately $39.40 per share, which means that investors would need the ETF to appreciate about 12.6% over the next two years to be in-the-money.

Risks Associated with Options

Stock options involve a greater level of risk than traditional stocks. In the above example, the investor could lose their entire $440 investment if the ETF drops below $35.00 per share in January 2016. These dynamics could actually save the investor money if the underlying stock falls significantly, however, given that they could only lose out on $440 and not the full $3,500.

China ETF share price: $25.00

Loss on equity investment: $1,000 ($10/share)

Loss on LEAP position: $440

Savings on difference: $660

Investors must also be cognizant of the premium they are paying to establish the position. In the above example, the ETF must rise more than 12.6% before the investor makes money. In-the-money LEAPS tend to be more expensive, while out-of-the-money LEAPS tend to be cheaper, although the prices are largely in-line with the amount of risk that the investor is taking by establishing the position.

There are many other risks that investors should also consider when buying options as a stock substitute:

• Exercise Risks. Investors are required to pay the full amount necessary to buy the underlying stock if they exercise their option. For example, $3,500 would be needed to exercise the option in the above example.
• Volatility Risks. The value of a stock option depends largely on the volatility of the underlying stock, which means that an option may lose value if the stock becomes less volatile over time (even if the end result is the same).
• Time Decay Risks. The value of a stock option also depends on the time remaining until expiration, which means that an option loses value over time (even if the end result is the same).
• Liquidity Risks. Some stock options – particularly in foreign markets – may experience less liquidity than the underlying stock. While exercising the option is still the same, it may be harder to buy and sell at good prices.

Key Takeaway Points

Stock options provides international investors with a great way to build exposure to foreign markets in addition to just reducing risk via protective puts. LEAPS are long-term stock options that provide the flexibility needed for long-term shareholders. However, investors should carefully consider the many risks involved before purchasing options, including the greater risk of complete loss.