Using OptionsPrinciples & Guidelines
Two Approaches for Option Strategies
There are two very different approaches for retail investors in the options market, trading and investing. Strategic Option Investing relies on Guiding Principles for both applications.
Option Strategy Matrix
Principles for Using Options (Trading & Investing)
1) Only use option strategies in actively traded underlyings with option activity
Avoiding illiquid option markets is a keystone in stock option trading. A lack of liquidity puts the trader at disadvantage. The friction of bid/ask spreads may overshadow the potential of any trade. Further, an illiquid market may force situations from which traders struggle to withdraw.
Option investors often look to purchase DITM, long expiry call options. However, calls that are DITM and calls with long expirations are both thinly traded relative to ATM near term options. In combination, the long expiry, DITM calls are likely to have large bid/ask spreads with relatively few active participants for those specific contracts.
Fortunately for option investors, purchasing long expiry options distributes the effect of friction across a long time period. Still, a moderately active options market at the desired contract should exist before investing.
2) Employ strategies as a net premium seller
Long premium strategies generally have lower chances of realizing a profit. As time passes, these strategies lose premium value. Rising implied volatility adds value to long premium strategies. However, implied volatility has historically trended above realized volatility, making long premium strategies unprofitable in general.
Short premium strategies have higher chances of profitability, though often with increased risk. Max profit is capped, unlike the generally unlimited profit potential of long premium strategies. Time passage benefits short premium strategies, as does a contraction in implied volatility.
Strategic option investing takes advantage of methods to offset any long premium. Short positions may be taken against long positions to eliminate long premium, whether in concurrent expiration or near-term expirations. Additionally, incremental cash availability may be employed in low-risk investments to offset any positive premium positions.
3) Don’t neglect dividends in assessing option strategies or stock replacement
In general, avoid using options as a stock replacement strategy for dividend yielding assets. Option ownership does not provide the holder with rights to dividend distributions.
SOI recommends against stock replacement via options for any assets with dividend yields greater than 2%. For assets with dividends ranging from 0-2%, stock replacement may be appropriate in specific situations where a plan is in place to capture value greater than the circumvented dividend.
4) Use a variety of strategies in a variety of situations when trading options
Option traders rely on high transaction quantity in various strategies to benefit from probabilistic distributions of underlying movement. Using a single strategy in all market situations creates an environment in which mathematical distribution of results no longer provides overall value to option traders.
An analogous situation would be a casino that closed all games of chance except for blackjack, but then only opened a single, high limit table in which the dealer only accepted bets for a ten-minute period each evening. The lack of probabilistic distribution in results places the casino in a position of high volatility for returns.
Option investing often focuses on a smaller variety of strategies, though the option investor is banking on the growth and success of its equity positions in business rather than in short-term market fluctuations.
5) Allocate and diversify funds appropriately to reduce unsystematic risk
Investors and traders should allocate funds across various types of investment vehicles as appropriate to their financial plan, risk tolerance, financial goal, time frame, and preference.
In addition, funds allocated to specific types of vehicles, such as equities, should be diversified to reduce unsystematic risk associated with any given company, industry, sector, or characteristic. Due to its inherent diversification and history of strong performance, the S&P 500 makes a great foundation for any equity portfolio, whether held as a mutual fund, ETF, equity option, index option, future, or other vehicle.
Research has proven that adequate diversification improves a portfolio’s overall risk/return ratio to the benefit of the investor.
6) Investors must focus on the business, not short-term market fluctuations
Option traders focus their efforts on movements in the equity markets. Volatility and price fluctuations provide traders with the premiums necessary to successfully execute, manage, and exit option positions.
Equity and option investors, however, focus on the companies behind the stocks. Business strategy, growth, fundamentals, opportunity, and management capability all impact a company’s stock. Investors make decisions to buy portions of companies (stock) based on pricing, opportunity, and expectation.
Unlike traders, investors make these decisions as long-term commitments. For success, investors must distance themselves from the emotional impact of short-term fluctuations. Provided the investor still believes in the company’s future, short-term fluctuations should be ignored.
A great quote to remember is, “All of the worst investing decisions I have ever made begin with the word ‘Sell.’” -unattributed
Two Different Approaches for Two Different Uses
Trading is the most common application of options in the retail market. Trading capitalizes on the short-term market environment with mechanical strategies applicable to a wide variety of situations. Less utilized in practice, but the focus of Strategic Option Investing, are the long-term investing strategies that employ options for enhanced returns.
Two Different Types of Strategies
Option Investing Principles
1) Utilize options based on notional capital, not capital employed
2) Invest capital saved by option usage in low-risk, incremental yield opportunities
By employing deep in-the-money (DITM) options, the investor will save a significant portion of the cost required to buy shares outright. However, the investor’s exposure to stock price fluctuations will be equal to that of fully purchased shares.
For example, assume XYZ stock at $100. Instead of buying 100 shares for $10k, the investor purchases a 1-Year LEAP call option with a $50 strike price for $51k. The investor has exposure to XYZ stock as if he owned the 100 shares, but at roughly 50% of the cost. Rather than buy a second LEAP which would double the exposure, Strategic Option Investing principles might have him invest the $49k saved in a low-risk bond yielding 6%, or ~$3k in a year. The bond yield covers the LEAP option premium of $1k with an additional $2k in return. The investor will recognize an incremental +2% annual return on the XYZ option position as compared to a straight stock purchase.
3) Commit to a written, disciplined investment plan for every leveraged investment
For every leveraged position, the investor should document a plan for the investment. Questions to address include:
– Will the option be sold or exercised if it is in-the-money (ITM) at expiration?
– If there is a covered call written on a position, will the underlying be exercised or sold to satisfy the covered call? If not, what parameters will define the resulting decision?
– Under what situations or environments will positions be rolled (up, down, or out)?
– At what level will investors take profits or close out losses? At what levels or time periods will positions be increased or decreased?
– If the stock establishes a dividend policy or increases dividends, how will distributions impact the decision to hold option contracts?
4) Know the difference between option investing and option trading
Always know and understand whether a position is an investment or a trade. Trades are short-term opportunities to capitalize on market conditions. Investments are long-term commitments to a company and a strategy for long-term success
– There is nothing wrong with option trading, but the rules, mechanics, decisions, and actions associated with trading are very different from investing. Do not apply trading strategies to investments, or investment strategies to trades. Know the difference. Document the difference.
– Investors utilize stock options to buy, sell, protect, and leverage stock positions. Options can reduce risk and increase returns when used correctly.
– Traders apply various strategies to stock options in specific market environments to capitalize on the implied volatility and risk in the marketplace.
5) Understand how and why option prices change
Stock options behave very differently than stock shares. Traders and investors both need to understand the factors that drive option prices. The various factors that influence option prices are generally known as the Greeks, a few of which are summarized below. Full understanding requires detailed knowledge of both first and second order Greeks. A basic understanding of the fundamentals below is required for even a rudimentary knowledge of option price fluctuation
– Delta: the change in option price with respect to (wrt) a change in the underlying
– Vega: the change in option price wrt a change in implied volatility
– Gamma: the change in delta wrt a change in the underlying
– Rho: the change in option price wrt a change in interest rates
– Theta: the change in option price wrt a change in time to expiry
6) Manage positions for times of increased volatility such as earnings releases
All options go through phases of increased volatility, both implied and realized. For general equities, quarterly earnings releases often mark high volatility periods. Political events, natural disasters, military actions, cultural shifts, and general changes in the environment all impact the volatility of both general and specific derivative securities. However, the most common, forecasted, and known volatility increase for any single equity remains the periodic earnings release.
Earnings releases have a great impact on option traders, as equity underlyings often have significant implied moves either up or down. For investors, earnings releases have significantly less importance since long-term horizons generally smooth out short-term volatility. One note of caution, however, is focused on investors with covered calls. Holding a covered call through an earnings release provides increased risk that the underlying may bypass the covered strike requiring action by the long-term investor. Generally, long-term investors try to avoid covered calls during earnings release dates.