Investors Turn to Options to Minimize Risk

Judging by the growth in the use of exchange-traded options, the answer is, “Nope, not really.” Or at least, “Even if I feel lucky, I want to be able to sleep at night.”

The result is that the traditional use of options—to transfer or minimize risk, rather than to take risks to amplify returns—is back in the forefront. It isn’t all about using options to gamble.

“Most people like to see gains in their portfolios,” says

Leslie Beck,

a certified financial planner with Compass Wealth Management. That love for gains, however, is exceeded by a hatred for losses, Ms. Beck adds. Options-based products “give me a way to tell them, I can limit your downside while still giving you a way to participate in any market growth. Clients really like the idea of minimizing their risks and smoothing the trajectory of gains and losses.”

Ancient Greece

The use of options can be traced all the way back to ancient Greece, when Aristotle recorded the case of a savvy philosopher in the sixth century B.C. Thales, expecting a bumper crop of olives, placed a deposit on the use of the olive presses used to extract oil. That gave him the right—but not the obligation—to demand first use of the olive presses, a right he sold at a premium when his forecast proved correct.

The modern version of options is just as straightforward: They give buyers (in exchange for a small payment known as a premium) the chance to buy or sell a security or asset at a specific price and date in the future.

To be sure, Thales was also speculating when he put down his deposit on those olive presses, and today’s investors also can use exchange-traded options to bet on everything from individual stocks and indexes to commodities and the prices of exchange-traded funds.

The math underlying this approach is alluring: You can control the same amount of shares or other assets using a fraction of the capital if you use options rather than buying a security outright.

In the fourth quarter of 2021, when volatility in the financial markets spiked, so did the average daily volume in options. Investors witnessed the same pattern in the just-ended first quarter, when average daily volume once again hit 25 million contracts. The Cboe Options Exchange (formerly Chicago Board Options Exchange) expects options trading on all exchanges in the U.S. to set its fourth consecutive record this year. It forecasts trading volume will hit 11.6 billion contracts, up from 10.3 billion in 2022 and about four billion a decade ago.

There’s no completely accurate way to gauge how much of this surge in activity comes from those trying to slash risk as opposed to those willing to embrace it. But it is worth noting that along with the growth in options trading has come the rollout of new mutual funds and exchange-traded funds that offer investors a portfolio that consists of long positions in stocks or other securities, combined with an options “overlay.” That is, managers buy downside protection using options, and then generate the income to pay for that by selling other options that would have the effect of capping the upside potential.

How funds fared

Funds in this category have seen their assets climb steadily, and were a rare beacon of light amid last year’s carnage. Calamos Investments, a veteran in the options world, launched

Calamos Hedged Equity

(CIHEX) fund in 2014; last year, though it had a loss of 11.1%, it still gave up less ground than either broad stock or bond funds. Other funds in this burgeoning category—such as

Gateway Fund

(GATEX) or

JPMorgan Hedged Equity

fund (JHQAX)—offer returns with a similar pattern.

“When the market is really running hot, as it was at the end of the fourth quarter of 2021, I would recommend investing any new cash in products like these rather than an outright, long-only index fund” to protect existing gains from future downside, says

Joseph Romano,

a certified financial planner in North Wales, Pa. “Owning a fund like these by last year looked like having a life raft handy while sailing on the Titanic.”

Ms. Beck, who puts some client money into the J.P. Morgan fund, says that its managers’ use of options helps both her and her clients sleep better at night. “Using an options-based fund gives me a way to tell them I can limit your downside by 15 percentage points,” she says, “and I don’t have to trade away all the upside or try to time the market.”

Ken Nuttall

says he learned to always look at the worst-case scenarios when he worked for J.P. Morgan’s derivatives department, and he carried that approach into his new career as a financial adviser at BlackDiamond Wealth Management. More of his clients are adopting a similar perspective, he says, and are willing to employ options or invest in funds that use options-overlay strategies to manage what they see as a growing array of risks.

“We’ve always talked to clients about risk, and told them that we have tools at our disposal to address this, but in the last few months, people have gone beyond simply understanding what we say to appreciating it thoroughly and being relieved that there’s something to be done,” Mr. Nuttall says. In his case, he prefers to use an emerging category of funds dubbed “buffered” or defined-outcome ETFs, which employ options strategies to cushion the downside exposure to some extent, and in exchange limit upside potential.

Puts and calls

All of these ETFs and mutual funds use some combination of call options and put options (respectively, options that give holders the right to buy or sell the underlying security) to protect investors from some downside risk. And investors—if they have the knowledge and patience to devise such a strategy for themselves and the time to monitor it closely—can adopt a similar approach.

Paul Townsen,

a managing director and portfolio manager at Crossmark Global Investments in Houston, says that options offer investors a way to avoid a common trap—trying to time the market by fleeing when things look grim and buying on signs of improvement. (Several studies have demonstrated that individual investors often leave too late, capturing too much of the downside, while being slow to return to the market and missing out on a big part of a recovery.)

“It’s too easy for someone to throw their hands up and say, I’ll get back in when things settle down,” Mr. Townsen says, “but in reality it’s simpler and better just to keep participating in the market and using options to mitigate the downside.”

Nevertheless, Mr. Townsen adds, it’s still wise to get some kind of advice when putting in place trades that involve multiple options contracts, as these common approaches to managing risk often involve. “We’re putting on trades two or three times a day, and unless this is your day job,” he says, “it’s going to be tough to duplicate that effort and scrutiny.”

Ms. McGee is a writer in New England. She can be reached at reports@wsj.com.