September often brings increased volatility to the Market. It has certainly been the case this year. Questions about whether the Fed raises interest rates next week and the confusing Presidential election are certainly contributing to the rocky price action. But there’s a mechanical aspect to trading which plays a role too.
Friday was what’s called a “quadruple witching” day. Quadruple witching refers to a date that has 4 sets of options expire together. They are stock index futures, stock options, index options and single stock futures. It only happens 4 times per year. Historically, a quadruple witching day has been very volatile, as heavy volume causes a lot of crazy price moves as traders had to manage expiring positions and re-position their portfolios for new expiration cycles. Remember, options expire on the 3rd Friday of every month on the calendar. Electronic trading has helped smooth out the process, by making it more efficient. The shift from open outcry to electronic trading has created more liquidity and reduced errors. This allows traders to manage positions more effectively and causes less volatility in the overall markets.
As risk managers, we love the option market because it allows us to protect our positions and generate more income for portfolios. There are times when we buy options because we feel the reward is much greater than the risk taken. When it comes down to it, our goal with options is to enhance your returns while reducing your risk.
The options market can be quite confusing and it requires great discipline. Options can move fast. Very few investors use them. Options are contracts between a buyer and a seller, which give the buyer the right to buy or sell a particular security at a specified price on or before a specified date. It’s ok to read that sentence again. Options have a variety of useful strategies to protect stocks. We use options to hedge portfolios and individual securities while simultaneously minimizing risk and generating income.
Options can be viewed like insurance. Often, we use options the same way a homeowner utilizes homeowners insurance. We try to place protection on investments prior to a correction or downward move in the stock market. That’s called a hedge. It’s already in place similar to insurance in case of a flood, earthquake or fire. It’s too late to acquire insurance once the house is on fire and that metaphor holds true to options as well.
We mostly use covered calls to generate additional income, which also provides some downside protection to the stock. With this strategy we try to create a virtual dividend on a stock that might not pay one and seek to double the dividend for those that do. This is part of our total return strategy. Options strategies work really well in volatile markets, because premiums can get very big. That’s when we look to sell calls. Options can also come in handy with a boring, sideways market where we try to manufacture returns. The key to the options market is take what the market gives you. Our technical analysis helps us significantly in determining what type of options strategy to use and when to use them. Rest assured, your money is always working hard for you.
We expect this volatility to continue a little longer, but we’ve got you covered.
Let us know if you have any questions. It’s always great to hear from you.
By Mike Frazier & John Edelen