Advisors weigh in on the benefits of options as a hedge against concentrated stock risk

Shares of NVIDIA (Ticker: NVDA) are up 1,250% over the past 5 years. So for all the Wall Street wisdom about taking profits off the table, diversification or hedging single stock risk, those smart, lucky or brave souls who loaded up on the AI chipmaker and let it ride saw their play pay off.

Bully for them and their paper gain. May they enjoy it while it lasts because market history has proven that no tree grows to heaven.

And that’s why advisors have traditionally recommended hedging strategies for clients with concentrated positions in AI-related or any other stock. Because, heaven forbid, that stock collapses, leaving the holder with, well, one severely troubled tree.

Options are one method available to hedge risk. Nevertheless, there is some hesitancy among advisors to employ an options strategy against a concentrated stock position.

James Cordier, CEO of Alternative Options, blames that hesitancy on the high cost of the hedge itself. In his view, to get “real protection” against a swift or prolonged downturn in equity values one needs to purchase put options that are somewhat close to the money. 

“On an average year when the market is up 17% a portfolio manager would be looking at premium costs that could equal 3 to 4% of any gains in a given year. If equities have a less than stellar performance 3 or 4% now becomes a barrier that might equal half or more of any potential gains.  In terms of a bear market move, down 20% or more, the hedge could likely reduce the loss to approximately 10%,” Cordier said.

Put simply, a large cohort of money managers feel the client's appetite may not align with such high costs.

Eric Metz, chief investment officer at SpiderRock Advisors, however, believes the tide is turning and there is a growing adoption and comfort level with options today versus 5 to 10 years ago.

That said, he feels the inherent challenge to encompassing options for an advisor are many.  

“Number one among them is their time spent, as advisors are busy, running their practice, prospecting, financial planning whereas options portfolio management is prohibitively time consuming. Second, technology and systems to monitor, trade and scale options for an entire practice is challenging, and further the reporting and performance attribution of the value proposition through time needs to be consistently articulated, which many platforms lack the capability,” Metz said.

Elsewhere, Larry Benedict, CEO of the Opportunistic Trader, believes the main reason is that they do not understand how to utilize options correctly and they have little to no experience. Additionally, he said most advisors just sell calls against long stock positions, which causes them to just roll positions out when they go into the moment.

“In these cases, the lack of knowledge regarding managing options properly prevents these advisors from making money to the upside with little to no protection to the downside,” Benedict said.

GETTING A REAL HANDLE ON RISK

Cordier believes one of the biggest misconceptions about an options hedge is that it often winds up being a “wasted investment.” 

“On average the majority of money managers are interested in getting the full move up in bull markets and are willing to ride out bear markets as just part of the business. Quite often the conversation of hedging a portfolio through the use of options doesn't take place and thus stock picking and market timing becomes key,” Cordier said.  

Meanwhile, SpiderRock’s Metz definitively states that options “were and are built for prudent risk management.”

“Everyone must remember that the options are tied to an underlying, and they don't make or lose money without offsetting gains or losses from the underlying. When not used appropriately, specifically for speculative purposes, advisors and clients might not have a great experience,” Metz said.

As the market sits near all time highs, Metz adds that there may be “no better time than the present” to reevaluate incorporating these very useful tools into portfolios and an advisors' practice.

Finally, Benedict believes the lack of knowledge by the RIA community about options creates a false system that says options are risk.

“But when they are used properly, they give you defined outcomes and defined risk – they are the best way to hedge equity positions,” Benedict said.