Dale Jackson

Personal Finance Columnist, Payback Time

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At some point in the life of a retirement investor, the three basic asset classes – equities, fixed income and cash – are not enough to lower overall portfolio risk without sacrificing growth.

That’s where options can help lock in the savings you worked so hard to accumulate. Options and other derivatives can be the right option for older Canadians to generate safe income.

Derivatives get their value, risk and basic term structure from an underlying asset, normally a stock. Options give investors the right, but not the obligation, to buy or sell an underlying asset. 

It’s a lot for the average investor to wrap their head around.

Derivatives are like insurance policies covering all asset classes including equities, currencies and interest rates. Most are traded by large institutional investors, but more retail investors are turning to them in their registered retirement savings plans (RRSP) and tax free savings accounts (TFSA) as trading platforms become more sophisticated, and a larger segment of the population needs to protect their retirement savings from equity market turmoil.

COVERED CALLS

A popular option strategy that dovetails with other income strategies like fixed income, preferred shares and real estate investment trusts (REITs) is writing covered calls on stocks investors already own.

The writer, or seller, of a call gives the buyer the legal right – but not the obligation – to buy shares in the underlying stock at a set price (strike price) any time on or before a set date. If the stock rises above the strike price, the owner will likely be forced to sell at the strike price. If it remains below the strike price, the writer keeps the stock and any dividend it generates, and a premium paid by the buyer.

It allows investors to capture two sides of the investment coin: the underlying security and the option.

Investors on the other side of the trade buy call options to protect gains in high-flying stocks, which rewards call sellers (writers) with bigger premiums. 

ACCESSING DERIVATIVES THROUGH ETFS

The easiest way for most Canadians to access derivatives is through exchange-traded funds. Many investment platforms offer a variety of covered call ETFs that span the broader markets or specific sectors like technology and energy.

For example, one BMO covered call ETF tracks Canadian banks. As with most covered call ETFs, returns tend to be low. They are, after all, intended as a portfolio hedge. However, the current yield on the BMO Covered Call Canadian Banks ETF is nearly 7.5 per cent.

Another kind of derivative ETF tracks the Chicago Board Options Exchange (CBOE) Volatility Index, commonly known as the VIX, or fear gauge. The VIX uses futures contracts on the S&P 500 Index as a real-time gauge of expected price fluctuations over the following thirty days.

VIX ETFs are for retail investors who want to profit from volatility whether stock markets spike up or down, but they could backfire if markets flatline.

TAILOR-MADE DERIVATIVE STRATEGIES

Derivative ETFs tend to be one-size-fits-all and can be difficult to incorporate in an individual portfolio. A qualified advisor can devise a derivative strategy based on an individual’s risk tolerance and return goals.

They are better qualified to determine how much of a hedge is needed, how much protection it provides, how to correlate them with your current assets and when to take them off.

It’s important to know that not all advisors are qualified to sell derivatives, so be sure to ask.