The ability to properly utilize option strategies in a portfolio separates the average from the elite in the world of money management. A properly structured portfolio can use options to both maximize returns and minimize risks.
Call Overwriting: This strategy has historically benefited long term wealth creation and lowered overall portfolio volatility for attractive risk adjusted returns. A systematic approach, such as writing calls in names that become overbought on multiple time frames with close to the money options on short expiration time frames that maximize the ability to earn positive theta, can enhance returns. With predesigned screens for effective overwriting candidates we can target large cap names without earnings events and expensive implied volatility to capture maximum returns. This strategy is also a way to stick with strong trending stocks longer, lowering your cost basis via option sales, and being able to dictate exactly what level you are willing to sell your stock position. The increase in the options market liquidity along with lower transaction costs has made this strategy even more effective.
Stock Replacement: This strategy is an effective way to reduce risk while maintaining upside exposure, and does not have the performance drag of buying protective puts. By replacing your stock holding with a call option position, whether keeping the same net Delta exposure or share exposure, you also reduce capital requirements and allows for flexibility to redeploy cash to new investments. This strategy will be more effective in core holdings using longer dated options that minimized the negative impact of Theta (time decay), and using higher Delta calls to minimize premium paid. Keeping a close watch on implied volatility statistics and the skew of the implied volatility curve, we can select an optimal time to initiate this strategy. It is also important to keep in mind that option holders do not collect dividends, so this strategy is not always best suited for higher dividend yield positions although the interest on cash saved by using the strategy neutralizes much of the impact, basically a synthetic dividend.
Put Sales: This strategy holds many benefits over buying a stock you want to own in the market at its current price. By selling a put to open, it obligates you to own the stock if it is trading below the strike at expiration, but the beauty of the strategy is that you get to set exactly what price you are willing to pay for a stock. Once again utilizing implied volatility tools and skew, we can determine optimal times to employ this strategy. The main risk to the strategy is owning a stock at a cheaper level than it currently is in the future that you wanted to own anyway, and potential for the shares never to be put to you if trading above the strike at expiration, adding supplementary profits to the portfolio, or able to roll the puts out to a further data collecting more premium if the core thesis of wanting to own the stock remains intact. This strategy allows you to gain exposure to stocks you want to own while limiting the capital investment, and added benefit of generating additional portfolio income as the put premium decays. We have the added benefit of monitoring institutional options flow to be able to see what the “smart money” is willing to own at a defined price point, and can capitalize on that intelligence.
Risk Reversals: This strategy can be a very lucrative one and is a combination of some of the prior strategies discussed. In the case of a bullish risk reversal, you will sell a put and at the same time purchase a call, at different strikes. If the strike choices allow for the strategy to be put on at a net credit, it has many of the same characteristics of a put sale, but the added benefit of being able to generate even more income with a move higher due to the long call exposure. This can once again be a way to express a willingness to purchase a stock at a defined price while also not wanting to miss out on the upside potential. It is a strategy that can also be used to replace a stock position. In the case of a bearish risk reversal, the opposite applies, you define a level where you are willing to be short a stock while also benefiting from any downside move.
Ratio Spreads: This is a more complex strategy and used less frequently but does have some advantages. When put on for a net credit the strategy minimizes risk to one direction, and can be effectively utilized when a position moves to an extreme oversold/overbought level. It can be used nicely when volatility gets rich and skew slope gets steep, allowing to put on protection in a low cost way with the risk being cost averaging into a long position willing to own more shares, in the case of a put ratio spread. Combining the strategy with technical analysis that determines important support/resistance levels can enhance its effectiveness.
Hedging Market Exposure: Overall market exposure can be hedged in a number of ways, but most commonly via put options in SPY, IWM, and/or QQQ, or VIX calls. The ability to observe implied volatility trends and keeping a close eye on market breadth and internals allows for picking the optimal timing of hedges, and then analyzing the implied volatility skews enable structuring optimal hedges, often via spreads to avoid some of the downfalls of hedging such as time-decay. Furthermore, daily analysis of the large institutional options flows allows us to see when and where the smart money is positioning with hedges, and can use that information to better protect/enhance our portfolio.
Hedging Sector/Industry Exposure: The popularity of industry-specific ETFs is allowing for much better strategic hedging in today’s market, and most of these have much lower volatility premiums in the options that the stock components, allowing for more cost-productive hedging. When overweight a particular sector/industry, we can use put options in the ETFs for protection, and capture the outperformance of the stock selection.