Options as a Long-term Strategic and Short-term Tactical Tool
Depending on the investor's objectives, investment advisors can deploy option strategies that can be structured to yield benefits under nearly any market condition.
Certain option-writing strategies provide investors with alpha income opportunities while certain hedging and spread strategies can be structured to protect concentrated assets against market volatility.
Here are a few types of investment advisor clients who might benefit from option strategy programs:
A retired executive maintains a concentrated position in his former company's stock.
Client objectives in this instance may be three-fold: enhanced return, protection and a targeted sale price to permit diversification. Advisor can create a custom strategy portfolio to:
1) increase income from held assets;
2) hedge the concentrated underlying against market volatility; and
3) permit share sales at or near desired price targets.
A multi-family office holds a large concentrated position in a single stock and seeks to boost total return.
The manager for a multi-family office holds a significant concentration of a single-name stock and wants to enhance return but effectively manage risk. Asset managers can create an option program that seeks to enhance their total return and reduce volatility while guarding against the sale of any stock.
Investors seeking to enhance income or total return, protect concentrated value, and/or implement a timed sales strategy.
Considering tax, income and diversification objectives, high net-worth investors can deploy option strategies in conjunction with other portfolio management programs to achieve optimal returns.
Short-term market volatility spikes creating new risk exposure to entire client portfolio.
Advisors can deploy index or ETF hedging strategies to manage volatility through periodic upheavals in the market.
The above are only a few examples of potential investors who may benefit from option overlays.
Building a repeatable process
Before entering into any options position, there are four basic parameters you need to evaluate. These parameters are distinct from the variables which comprise an option?s price, and should be part of your methodology when establishing and managing an option position.
Before we can jump into any option strategy, you need to develop a market outlook; in other words, you need to develop an overall perspective on a general market trend.
For example, evaluate the chart of a major index or benchmark, and determine whether the market is in an up, down or neutral trend. It is critical that you have a perspective or opinion on how the overall market or benchmark is trading or trending for you to make a correct strategy decision.
Once you have an opinion on the overall market, determine how the trend of the individual underlying you are considering stacks up against your opinion of the benchmark. The objective is to form a bias as to whether this underlying is going with or against the overall trend of the market.
Now that you have looked at a picture of the market and developed a trend outlook based on the charts and/or fundamentals, consider how the underlying's current options are being priced.
An option has the market?s current anticipation or expectation of a potential move built into the actual price. This is known as "implied volatility". So why not use this in our evaluation stage?
Based on current stock price, specific timeframe and the current implied volatility, we can derive how much the stock might move (up or down) in that time frame within 1 standard deviation. This helps with strike selection and assessing Probability of Profit for any strategy you are looking to deploy. See the calculations below:
Calculating Expected Move over a Specific Timeframe
Expected Price Change = Current Stock Price x Implied Volatility (IV) / (Square Root of Trading Days / Trading Days in a Year).
1 day: (Stock Price x Implied Volatility) / 15.87(SQRT 256)
7 days: (Stock Price x Implied Volatility) / 7.21(SQRT 52 WEEKS)
30 days: (Stock Price x implied volatility) / 3.46 (SQRT 12 MONTHS)
Note: Most brokerage platforms with advanced option capabilities have tools which do these calculations for you so you don?t have to break out your calculator each time you?re considering a new options strategy.
Once you have established an estimated potential move calculation you need to assess volatility.
To do this, view the underlying's volatility chart to help determine if 12-month implied volatility is high, moderate or low. This will: 1) help you assess whether or not you are paying a bigger potential premium; 2) help in potential strike selection (i.e. In-, At- or Out-of-the-Money); and 3) help determine the most optimal strategy for this environment.
Following these steps in conjunction with prudent position size management may not only improve your success rate, but also, and more importantly, may help you identify and deploy the most optimal strategy.
The end result is a deeper understanding of the market that may put you in a more flexible position to react to available opportunities.