Incorporating Options in Equity Portfolios
Options can lower our cost basis per trade, increase probability of profit, hedge risk and offer additional statistical advantages.
Options can be a versatile instrument to complement our stock investing strategies. They allow us to better control risk, increase probability of profit and generate satisfactory returns during side-way markets. The public has a generally misguided notion that options trading is inherently riskier due to the leverage options offer. In truth, it depends on the specific strategies employed, and options can be a reliable way to reduce portfolio risk and capture additional sources of returns. In this article we’ll focus on how we can use options to complement an existing equities strategy.
I will not be going through the basics of options, including definitions, valuations and the Greeks. There is already an extensive literature on these. The team at TastyTrade have done splendid work in explaining options to retail investors and I recommend watching their YouTube video series “Mike and his White Board” to grasp options basics. I’ve personally learnt a lot from their videos and live broadcasts.
Investment strategy is about capitalizing on statistical advantages
Creating an investment strategy designed to beat the market on an absolute or risk-adjusted basis is not easy. For the 15 years ending in Dec 2016, more than 90% of actively managed U.S. large-cap, mid-cap and small-cap funds did worse than the S&P 500, despite the fees they charge. Further, the rules of the game have changed with the emergence of quantitative, machine learning algorithm funds managed by armies of PhD s. Nobody can truly predict what the price of any given stock is going to be one week from now.
In a world where forecasting the future is impossible, investors rely on persistent themes of high probabilities, such as:
• Value investing: Long-term historical out-performance of value stocks over growth stocks due to periods of extreme investors’ optimism and pessimism, and mean reversion of fundamentals.
• Diversification of risks: Consistency of correlations between asset classes encourages investors to diversify to generate superior risk-adjusted returns. The Risk Parity model takes this concept further.
• Small-cap Premium: Small-cap companies with high returns on capital, high payout ratio, stable earnings and low volatility have consistently outperformed the market across time periods and markets.
• Risky Assets outperform over the long term: Historical returns over multiple time periods and rational investors’ expectations suggests that in the long-term, investors will generate higher returns by over-weighting risky assets such as equities and real estate over risk-free assets (excluding inflation and reinvestment risks) such as government bonds and cash. Because rationally, investors demand higher returns to compensate for the additional risk.
Options grant the investor additional statistical advantages. In particular:
• Implied Volatility (IV) Overstatement and Volatility Mean Reversion: Statistically, implied volatility (IV) and hence the premiums received on selling options are too high on average. Compared with the level of volatility that ensues. According to TastyTrade’s research, volatility tends to be overstated more than 80% of the time due to current fear of future uncertainty. This is further influenced by the level of market volatility at the time, and the stock’s volatility percentile to its past. This recurring phenomenon means that option sellers on average, turn a profit, as they are over-compensated in premiums.
• Time Decay of Extrinsic Value: As time passes, assuming no change in the underlying’s price or implied volatility, options lose value, benefiting sellers who can close their positions by buying the options back at a lower premium or letting them expire worthless. Thus, even in sideways markets with no change in underlying’s price, option sellers are reaping value from time decay.
• Lower Cost Basis per Position: Collecting option premiums on a position lowers your cost basis, break-even point and increases your probability of profit. Suppose you are bullish on Facebook as of 2nd Apr 2018. Instead of purchasing 100 shares at the closing price of $159.79, you can elect to sell one 18 May 2018 (46 days to expiration), 38-delta put option with a strike price of $155 and collect $6.65 in premiums. Your cost basis and break-even point for the position is now $148.35 ($155 - $6.65) instead of $159.79 by purchasing the stock outright. Statistically, you have about a 75% probability of making a profit on this trade, compared to approximately 50% by purchasing just stock (other variables held constant).
Naked puts to establish long positions
As aforementioned, selling put options can generate statistically favorable outcomes for the investor and generate returns in the form of option premiums even when the underlying trades sideways. Take the earlier example, if Facebook remains above $155 upon expiration, the investor would have generated 4.5% returns on his/her capital at risk ($148.35) in 46 days. Hypothetically, if all variables remain constant and the investor repeats the same trade for one year, he/she would have reaped an annualized return of 41.6% on capital at risk. For the stock investor however, his/her returns would be 0% if Facebook’s stock price remained unchanged after one year.
Because statistically, not all your naked put positions are likely to be exercised (hence granting you the full premium received), you are able to sell more options with a total capital at risk that exceeds your account’s value. In the derivative’s world, this effect is known as Buying Power Reduction Effect (BPE). And managing it is critical to managing your portfolio’s expected returns and risks. More conservative investors may utilize approximately 20% of their Total Buying Power, while aggressive ones may prefer 40-60%. It also depends on your overarching investment strategy and how you manage risks. A market neutral strategy type, may utilize more BPE, as market risks are reduced through other mechanisms.
Buying Power Reduction Effect (BPE) - Your leverage metric
Total Buying Power is our capital available to place trades. For example, an investment account without margin of US$100k has US$100k in Total Buying Power to purchase stocks. Buying Power Reduction Effect (BPE) is the reduction of our Total Buying Power when we trade derivatives like options. BPE is essentially what your brokerage firm considers your risk for a given trade.
For TD Ameritrade (platform I use), the Buying Power Reduction Effect (BPE) of selling uncovered or naked options is the higher of:
a) 20% of the underlying stock less the out-of-the-money amount, if any, plus 100% of the current market value of the option.
b) For calls, 10% of the market value of the underlying stock PLUS the premium value. For puts, 10% of the exercise value of the underlying stock PLUS the premium value.
c) $50 per contract plus 100% of the premium.
The following example is taken from TD Ameritrade’s margin handbook:
Action: Sell six naked puts of PQR Corp
Deliverable Per Contract: 100 Shares of PQR
Market Price of Security: $81.25
Market Strike Price: $80
Options Premium: $2.50
In this example, the Buying Power Reduction Effect (BPE) would take on Calculation A, as it is the highest. Assuming you had Total Buying Power of $100k, performing this trade would reduce it by $10.5k.
Note that your total capital at risk for this trade is ($80 - $2.50) x 600 = $46,500. 4.4 times what the BPE is, offering you substantial leverage. For investors with Portfolio Margin, the leverage effect is often greater as the brokerage uses a risk-based methodology that sets margin requirements for an account based on the largest projected net loss of all positions in a product group using a theoretical option pricing model. With multiple positions of low correlations, Portfolio Margin offers the investor a lower BPE per trade.
Each position’s BPE changes as the underlying’s price and implied volatility changes. Should your positions move heavily against you and exceed your Total Buying Power, a margin call will be issued. Thus, monitor your Buying Power and ensure you aren’t over leveraged. Always know what your total capital at risk is. It should be evident now, that options trading can either be less risky than outright stock investments if you limit your use of Buying Power to your initial capital and write out-of-the-money puts, or riskier if you use more Buying Power than what your reserve capital can cover.
As a general guideline for new to options investors and more conservative investors, limit your exposure to 20% of Total Buying Power.
Covered calls – The follow up
Continuing with our Facebook example, suppose Facebook’s stock fell to $155 and remained there until the options expiration date (18 May 2018). Our option was exercised, and we now own 100 shares of Facebook. Our profit for the trade thus far is the option premium we received - $6.65 (Actual profit = $6.65 x 100 shares = $665 as each options contract represents 100 shares of an underlying).
If we were still bullish on Facebook but would like to collect some option premium for the time being, we can opt to sell a Facebook call option. Because we own the underlying stock, there is no additional risk or Buying Power Reduction Effect (BPE) in doing so. There are two reasons we might want to do this:
• Reduce our Cost Basis further and hence improve our probability of profit: Assume all other variables remain the same, we can sell one 46 days to expiration call option with a strike price of $170 for $3.30 in option premiums. This reduces our cost basis from $148.35 to $145.05 ($148.35 - $3.30), improving the likelihood that our position in Facebook will be profitable. Now Facebook’s stock must fall below $145.05 for our position to be losing.
• We do not anticipate Facebook’s stock to move above $170 for the next 46 days: Statistically, the probability for a move to $170 from $155, assuming all variables held constant, is approximately 30% at this point. Suppose Facebook’s stock reached $170 by expiration date. Our stock would be sold at $170 for a net gain of $18.30 ($170 - $155 + $3.30). *Note that this profit does not include our previous put option profit of $6.65, for a total profit of $24.95 on Facebook. If we had simply held onto the stock, our profit would have been $15 ($170 - $155). Thus, unless we are confident an upcoming catalyst would shift Facebook’s stock above $173.30, we are better off selling the covered call.
Scaling into trades
I am a strong believer of scaling into positions and avoiding “all in” moves (although I do love poker). It allows me to systematically build up to my desired position in an underlying and take advantage of price pullbacks that occur. Because sharp moves to the downside are almost always more severe than moves to the upside, I believe this system yields additional value. Options are a great tool to implement this with.
Returning to our Facebook example, suppose we have just written the covered call on our position but would like to eventually have a net exposure of 300 Facebook shares (Currently we are long 100 shares). We can opt to write another put option at the 30-delta mark (30-delta translates approximately to 30% probability of exercise), at the strike price of $145 for a premium of $5.00.
Now we own Facebook’s stock at $155, sold a covered call at $170 for $3.30 and sold a naked put at $145 for $5.00. Let’s examine 3 scenarios:
• Facebook remains $155 at expiration: Both our options are not exercised, we retain our net exposure of 100 shares and can proceed to write the naked put + covered call again (targeting an eventual 300 shares). Our net gain is the sum of put and covered call premiums - $8.30 ($3.30 + $5.00)
• Facebook falls to $145 at expiration: Our put option is exercised; our covered call is not. We now have a net exposure of 200 shares and can proceed to write the same spread (at different strike prices due to the change in underlying price). Our net loss on the position is $1.70 ($155 - $145 - $3.30 - $5.00). However, our net P&L for Facebook remains positive as we’d add back the first put we sold at $6.65 for a net profit of $4.95 ($6.65 - $1.70).
• Facebook reaches $170 at expiration: Our covered call is exercised; our put option is not. We now have a zero-net exposure to Facebook and can re-evaluate the relative attractiveness of opening a new put position at this price. Our net profit on the position is $23.30 ($170 - $155 + $3.30 + $5.00). Our total profit on Facebook thus far is $29.95 ($23.30 + $6.65)
We can repeat this practice until either (1) We have achieved a net exposure of 300 shares, from which we will only be selling covered calls and not naked puts, or (2) Facebook’s price has risen higher than what we believe it is worth.
This system allows us to constantly reduce our cost basis, improve our probability of profit and reduce the effect of a severe stock price meltdown on the portfolio.
Hedging risk exposure
Suppose we are bullish but uncertain about a stock and would like to hedge our downside exposure to a pre-determined limit. Selling an put Spread as opposed to a naked put can offer such as hedge.
Let’s rewind back to our initial naked put position in Facebook which gave us $6.65 in premiums at $155 strike. This time we forecast a potential market correction and while we still favor Facebook as an investment, we’d like to limit our downside risk. To achieve this, instead of writing the naked put, we can sell a 155/150 put spread for a premium (net credit) of $1.70. This means we are selling the $155 put option while simultaneously buying the $150 put option. Our max profit here is $1.70 and occurs when Facebook remains above $155. Our max loss is $3.30 ($155 - $150 + $1.70). Our break-even point is $153.30 ($155 - $1.70).
Other useful information
There exists plenty of nuances in options, here are 3 that may be particularly helpful when starting out:
Implied volatility percentile – Determining the opportune time to sell options
Implied volatility percentile or IV percentile ranks the average implied volatility of an underlying today relative to its past (typically 12 months). Statistically, option prices are overstated to a greater degree when IV percentiles are high compared to when they are low. When presented with two interesting companies you’d like to build positions in, all else held constant, the one with the higher IV percentile should be selected. Preferably greater than 50%. High IV percentiles, especially when they translate into high absolute implied volatility, also enables us to go further out-of-the-money and still capture a reasonable premium.
Be careful of relying solely on IV percentile, especially when they are very high (greater than 80%), as they are usually high for a reason. For example, an earnings announcement may be around the corner, or the company could be pending the result of a class action lawsuit. For some small-caps, a very high IV Percentile may be the result of a group of investors acting on sensitive non-public information. A careful inspection of the nature and potential impact of catalysts is required before proceeding.
Days to expiration – Maximizing theta decay
Selection of option days to expiration (DTE) depends primarily on the investor’s specific strategy and forecasts. It is important however, to recognize the nature of theta or time decay and where possible, incorporate it into your overall strategy.
DTE selection, all else held constant, is essentially the act of balancing the premiums you receive vs rate of theta decay. Assume we are talking about a slightly out-of-the-money (OTM) option, the longer our DTE, the higher the premiums we receive but the lower our rate of Theta decay. Conversely, the shorter our DTE, the higher our rate of Theta decay, but the lower the premiums we receive. The rate of Theta decay for a slightly OTM option increases exponentially the closer it gets to expiration.
TastyTrade’s research recommends 35-50 DTE to achieve the highest rate of theta decay for a reasonable risk profile. With that duration, it is less likely that we’d be served unexpected, unpleasant surprises and still collect respectable premiums.
To illustrate the effect of the rate of theta decay, let’s consider our Facebook example once again. If instead of selling the 46-DTE put option at $155 strike for $6.65 in premiums, we had elected for the 109-DTE put option at $155 strike, we would have only received $8.65 in premiums. This is a duration extension of 137% (63 days) for a mere 30% increase in option premium. Annualized returns on capital at risk is 41.6% for the 46-DTE and only 21.2% for the 109-DTE option.
Delta – An approximation of probability of exercise / In-the-money (ITM)
We can use the delta of an option or the “Probability ITM” measure to help us determine which strikes to sell. For naked puts, if you are more conservative or less confident in your stock selection, the 20-delta put options may provide sufficient safety margin (depending on implied volatility levels) while still collecting a respectable premium. 30 to 35-deltas may apply better to a more confident forecast in the underlying.
For covered calls, the more bullish you are on the underlying, the lower you’d want the delta to give you greater upside potential from the underlying’s appreciation.
Because the deltas of your outstanding options affect your Total Buying Power directly, the choice of aggregate portfolio deltas can affect the number of positions you can hold at any given time. Lower average deltas allow you to open more positions given a Total Buying Power limit, compared to higher average deltas. Thus, some investors may prefer to sell more, further out-of-the-money options, while others may elect to sell less, but closer to the money options.
Use options to your advantage but use them wisely
Like many wonderful things in life that make us happier and more productive, but when taken in copious amounts, causes untold hurt and suffering, options can give our portfolios that extra edge but only if we are cognizant of, and adhere to, good guidelines. Limiting our leverage exposure by monitoring our capital at risk, we can use options to lower our cost basis per position, improve our probability of profit, scale positions systematically, hedge risks and capitalize on additional statistical advantages. The techniques mentioned in this article are only a brief introduction to the complementary benefits of options. A myriad of other techniques is widely available and used, and certainly more to be invented.