Do Options Belong in the Portfolios of Individual Investors?

Abstract

The use of options by individual investors has grown dramatically in recent years. The authors evaluate several popular options strategies, including portfolio insurance, life cycle investing, buy-write, and single-stock call-buying, from the perspective of an individual investor. The authors suggest that Expected Utility is the most appropriate metric for such evaluation, as it accounts for both return and risk, and naturally handles non-linear payoffs. They assess the different options strategies under a range of assumptions of asset price behavior, investor risk appetite, and option market pricing relative to fair value. They find that for a representative investor the benefit of adding options to the portfolio is at best quite small, and most of this improvement also can be achieved through periodic portfolio rebalancing. However, the benefits of options can be greater for several special investor categories and in certain market environments. The authors also identify several popular uses of options that are likely to be quite harmful to investor welfare.