Livewire Summer School: Using derivatives to your benefit

We use derivatives across the majority of our portfolios to improve performance and / or to reduce portfolio volatility. They help us consistently beat the market over time and improve the overall flexibility within our portfolios. We are almost entirely ‘sellers’ of options, and the bulk of our transactions are done on the index. We’re not speculators, we do use options to hedge market (and stock risk) at times, however, the bulk of our positions are there to take advantage of time decay and to sell volatility (risk).

Think of options in terms of an insurance company

Selling time is pretty straightforward, however judging whether or not we’re getting paid enough to be on the short side of volatility (risk) is more difficult. A useful way to think about the use of options as an investor is to think about it in terms of an insurance company.

Typically, an individual will buy insurance to protect against an unlikely scenario becoming reality – something from left field. It provides some piece of mind and in some instances, useful cover.

The insured event may play out in a short period of time and you’ll be thankful that you held insurance.

What’s more ‘probable’ though is that it may take a number of years or simply not happen at all.

The likelihood is that the insured person has spent money on insurance that in hindsight has not been needed - after all, the event that has been covered is an ‘unlikely’ scenario from a statistical standpoint.

An insurance company sits on the other side of that trade. They sell the policy at a price that they judge to be adequate compensation for 1: The time of the cover; and 2: The probability of the adverse event playing out.

Looking at my own monthly cost of insurance for house, vehicles, life, income protection, health, etc., I spend roughly $980 per month on insurance and on many occasions, have considered who has made the better trade here – me, or the insurance company? 

If we tie this back into using options, as an investor we have the choice of being the insurance company’s customer by buying protection, or instead being the insurance company itself, by selling protection. Nine times out of ten, we choose to be the insurance company by selling out-of-the-money index options.

Why Index Options rather than stock options?

Just like an insurance company, collecting money from one person and providing them cover is a lot riskier than having a broad spectrum of customers and collecting money from them all, knowing that statistically, some will get into some form of trouble. The same applies to the index versus singular stock options.

The probability that singular stocks have profit upgrades, downgrades, regulatory issues, management issues, etc., is quite high. On the other hand, if we think about the index, the 200 stocks that make up the ASX 200, by selling options against a basket of stocks, our exposure to each individual stock move is greatly reduced, which reduces the overall risk of the position.

Furthermore, history will show that markets, for a greater proportion of time will gradually move higher, gradually move lower, or broadly track sideways. Of course, events happen and markets can and will have a sharp reaction to it, however by selling index options we’re simply playing the probability card, recognising that at some point we will give back some of the premium we have accrued over time.

Right now, volatility in markets is low and option premiums are reflective of that. All is calm, however having the ability to sell volatility when it kicks up, and importantly, benefit from the erosion of time in my view can greatly improve portfolio returns.

The option strategy discussed above is known as a short strangle, and involves selling an out-of-the-money (OTM) call, and an out-of-the-money put simultaneously on the same underlying security, in the case above, the ASX 200 Index.

The strike prices can be determined by the seller based on risk preferences and income goals. For example, options with strike prices closer to at-the-money (ATM) yield greater premiums but have a higher probability of losing money.

Conversely, options with strike prices that are further out-of-the-money have a lower premium yield but a greater chance of making money.

The next decision comes around time: how long to be exposed for? Shorter-dated options pay less and longer dated options pay more, however, time decay picks up more towards expiry. We are typically sellers of shorter-dated options for that reason.

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Please note this is general advice and options may be suitable for sophisticated investors only. Discussion of insurance is for illustrative purposes only