Understanding Option-Enabled Accounts

So you’ve built an investment portfolio, and you’re buying and selling investments. Your portfolio has performed well but you are concerned that there could be a major market correction coming. What do you do?

One route might be to sell your investments and hold cash while you ride out the downturn. This could take a lot of time, and you may have to pay a lot of transaction fees if you hold a large amount of securities. Depending on your account type, you could also trigger capital gains.

Or, you could enable options trading on your account, which will give you the benefits of both a cash account and a margin account, access to options trading and the ability to buy “protective puts.”

What’s a protective put, you ask? Think of it as a risk-management strategy, a sort of insurance policy against potential losses on a particular stock. Essentially, you pay for the right to sell your shares at a price you specify. While it will eat into your profits to a certain extent, a protective put can also save you from bigger losses in the event that a stock price really tanks.

Buyer beware

If protective puts provide insurance against loss in the stock market, why don’t investors buy them all the time? As with any insurance, there is an associated cost. 

Options are a wasting asset because their time value erodes as the option approaches expiration. If you buy insurance for a long period of time, the time value that you will lose will be high. Short-term insurance will be less expensive because the time value will be less, but you will have to purchase more insurance (protective put options) when they expire.

Also, it is often during volatile times that investors seek to insure their portfolios. Volatility drives up the price of options, so insurance costs will be highest when you are most interested in being insured.

For these reasons, effective use of protective puts requires an element of market timing. If your options expire before the expected correction, they will not provide the insurance you desire. If you wait too long to purchase the options, the market may correct before you are insured. In other words, novice investors may want to steer clear until they’ve acquired a bit more investment experience. 

Want to learn more? Read Understanding Options to learn how options could fit within your investment strategy.

To open an option-enabled margin account

You can apply for options trading on one of your existing accounts. Visit the Forms & Agreements page and download the applicable form.

You can also choose to trade options in other account types, like an RRSP or RESP. Due to regulatory policy, RBC Direct Investing does not open accounts for non-residents of Canada.