This informal CPD article was provided by Options Insight, experts in providing basic trading fundamentals, live interactive trading simulations and in-depth derivatives trading workshops.
It’s true what they say, most options do expire worthless. But does that mean that buying them is a “mug’s game”? The systematic, risk premium harvesting, carry earning and yield hunting crowd would certainly answer with a resounding “YES” to that question.
A different perspective on buying options
Imran Lakha at Options Insight, with around 20 years of front-office options trading experience, has a slightly different perspective. If you understand how option premium behaves and the main factors that effect the pricing of these quite simple and commoditised products, then you can harness the power of optionality to benefit immensely when you tactically and selectively buy options.
There is little doubt that since the 2008 financial crisis, global central banks have effectively declared war on volatility and will do “whatever it takes” to backstop financial asset prices at the first signs of trouble. US equities just made new all-time highs this month and we are still fully expecting a 25 basis point rate cut from the Federal Reserve at the end-July meeting. There used to be a time that rate cuts were reserved for crisis prevention, how that has changed.
The powers that be are not even pretending anymore that asset price inflation is not top of the policy agenda. Rather than accepting the reality that these asset inflating policies are doing nothing more than increasing inequality between the rich and poor, they continue to cling on to the hope that the wealth effect will generate some kind of self-sustaining economic growth.
How the premium of an option will evolve through time
So in this volatility supressed world, how can buying options ever make sense? The key to answering this question lies in knowing how the premium of an option will evolve through time and different levels of price in the underlying asset. Granted that if you buy a call option because you are bullish on a stock and the stock drops like a stone and never looks back, you are most likely going to lose your premium and there isn’t much you can do about it. Likewise, if you buy a put option on the Nasdaq after the market has had a 5% correction and the volatility index (VIX) has risen from 12 to 25, the odds are you won’t see that premium again.
Holding an option to maturity
Buying an option and holding it to maturity means that you have to get the direction of the market right, and it has to stay there for long enough that your option expires in the money. All whilst, the time decay keeps eating away at your gains, leaving you exposed to the risk that your market view might have been correct but you still lost money. The way to buy options profitably is to think like a sniper, get in and get out quickly. Options give you leverage. You can spend a small amount of premium for a potentially massive return if you catch a big move and cash in on that move by selling the option out to realise your gains.
A powerful way to trade risk
If done correctly, buying options can be an incredibly efficient and powerful way to trade risk, generating alpha through superior risk adjusted returns. Apart from tactically buying options to gain leverage to a breakout in the price of a stock, a common use of options is for hedging. Many established money managers use put options to hedge their portfolios from macro shocks , enabling them to stay fully invested in the market but have confidence that their drawdowns will be limited if the market were to correct sharply lower. The most successful of these investors also know that once their puts have done their job in the event of a market crash, then they should monetise them by either selling them or rolling them in some way either to lower strikes or longer maturities.
Understanding the average duration of volatility spikes
Like with all forms of trading, you have to evolve with the market, and options buyers have had to understand that the average duration of volatility spikes is becoming smaller and smaller. Therefore, the window of opportunity to monetise hedges has also become narrower, meaning only the quickest and most prepared investors will actually be able to profit from owning these types of positions.
The fact that it has become so challenging to convert a long option position into profit has led to some investors abandoning using them and also many long volatility funds closing down due to consistently poor performance. This in turn has reduced the demand for options and meant the price for implied volatility has continues to drift even lower, presenting greater opportunity for those who dare to step up to the plate and spend premium.
I think most people would agree that it’s good to have options in life. In the uncertain world we are in today, I suggest that there may even be a time and a place for them in your investment portfolio.
We hope this article was helpful. For more information from Options Insight, please visit their CPD Member Directory page. Alternatively please visit the CPD Industry Hubs for more CPD articles, courses and events relevant to your Continuing Professional Development requirements.
