3 steps to make money with options

How can investors generate returns regardless of which way the market moves? In today’s article, I review the unique process which Vega Capital uses to achieve this goal.

1) Macroeconomic analysis

Over the long term, economies and corporate earnings are driven by productivity and population growth amongst other factors. But over the short to medium term, economies can be stimulated by consumers and businesses leveraging or deleveraging which drives their consumption patterns. This is, of course, a summarised version of Ray Dalio’s work.

The primary drivers of an economy in the medium term are thus debt creation, consumption levels, production levels and employment. Changes in the level of debt serviceability can either impair these factors or fuel them and this is what investors should keep a close eye on.

By understanding when serviceability becomes impaired on a widespread basis, an investor can decide when to have a long or short market bias for their portfolio. As it stands, the Vega Fund’s algorithms have determined that the bull market has ample room left to remain long (for now).

2) Selection

Stocks are typically valued via the Discounted Cash Flow method where investors input their expectations for a firm’s earnings trajectory and then perform a summed discount back to the present by some factor. The key here is investor expectations.

Options can be valued in a similar way, only the expectations we have are less so around earnings growth and more around changes in future stock price volatility (changes in earnings growth may influence volatility, but so can other things).

Volatility trading is a difficult subject to discuss in a short blog, but generally speaking the higher the implied volatility of an option is relative to the underlying security’s historical volatility, the more expensive it is and vice versa.

As in any form of investment, investors should wish to sell expensive assets and buy cheap ones. So if I have a view that the economy will do just fine, I’ll be taking a bullish position and selling the most expensively priced put options which the algorithms can find.

3) Hedging

When investing in options, investors can often take onto their books excess levels of risk which would be unwise to hold. Investors should hence have a rigorous risk management algorithm to identify and hedge out these excess risks.

As I’ve discussed previously on Livewire, there are many alternative methods to do this, however, I prefer using short-dated long VIX futures which tend to pay off handsomely when markets capitulate. These may come with a heavy monthly carry charge but the protection is often worth it.

And let's not forget being diversified as well as holding reserves of cash.

Summing it up

By entering into a portfolio of mispriced options which are directionally in-line with the debt cycle and hedging out the unpredictable yet inevitable bumps along the way, this framework aims to generate 10-20 per cent per annum during bull markets and over 50 per cent per annum during bear markets.

This is not a short-term trading strategy and requires consistent execution over multiple years. As is usually the rule in investing, patience is key.