Over the hundreds if not now, thousands of presentations I have done around the World, the understanding of what is risk, versus what people think it is, has been a central theme to almost each and every one and in particular when it comes to Options Trading Strategies.
Earlier today, I did an interview with a finance journalist from the Straits Times, the major newspaper in Singapore and Malaysia. I have got to know the journalist quite well, over the past few years, as we have been busy in Asia and as I type, I am flying up there to host an Options trading Strategies event.
One of the central themes to the interview was the common misperception out there that “Options are Risky!” and over the course of the interview, I set out the case for what proved to be the actual opposite.
Options are flexible
One of my senior traders was quoted not so long back as saying “options are the thinking man’s derivative” and this is a great truism. Options offer more flexibility than any other trading instrument out there – for example this little list of outcomes:
- Manage risk
- Protect or insure your shares
- Generate regular income
- Provide a profit from a rising market
- Provide a profit from a falling market
- Provide a profit from a sideways market
- Provide a profit from a wildly volatile market
- Unlock cash-flow from holding shares
- Enable underwater shares to be back to break even more quickly
- Directional plays up and down
- Allow you to target time decay and simply get paid for selling time
- Allow you to target volatility – buying or selling it, depending on your view
- Allow you to target differentials in performance between specific stocks
- Allow you to lock in a defined level of risk on the outset of the trade
All of these strategies have very limited and definable risk. Two options strategies that don’t – carrying an unlimited liability are two that we don’t promote – selling naked calls and puts – why? Because they carry virtually unlimited liability and their risk is off the charts.
But you have to watch the market all day to profit from options?
Um, no. Unless you are a trading junkie (apologies to those that are) there is a bit more to do with life, than simply watching the market all day. In fact the more you watch it, the chances are the less you will make!
The idea of investing is to generate cash flow, to provide choice and control – over how you spend your time etc and the strategies listed above are, for our clients, largely passive, thanks to our position management rules – when the target is hit – be that for profit or stop, we will exit the trade so no need to be watching and waiting and watching….
How about some diversification?
Great point – and within a portfolio, having several options trading strategies running across several stocks provides great diversification. For example, the bulk of your portfolio eg 80% of it may be sitting in covered calls. Why? Generating cashflow of course. But more importantly its at the lower level of the risk spectrum – and to be more precise, less risky than simply owning the shares.
Also, within your covered call holdings, there can also be diversification – not just simply across different stocks (having 4 banks in your portfolio is not diversification) but instead across stocks in a couple of sectors. Additionally, the actual call writing may vary too – for example if you are looking to simply generate maximum income, selling at the money call options would enable you to generate a big premium income.
Yet you may have a couple of stocks where your outlook is more bullish – and hence you may be selling out of the money call options – so as to generate some income from the option sale, and some capital growth in the stock. Sounds better, right – until you consider that by going further out of the money, your rate of return will be more volatile – perhaps something you are not looking for (not sure what this means, ask us about our Options Mastery Education).
And then a couple of extra strategies!
Maybe your view is the stock will hover at around within a trading range – and you want to get paid for your view on this – hence the Iron Condor may be just what you are after. This is the use of a Bear Call and Bull Put spread, two credit spreads one high, one low, meaning that both cannot go wrong – one can at worst, and chances are, the stock will sit in the middle anyway so both trades pay off! Again, this is the sort of thing that we teach and coach within Options Mastery, our advanced options program. While this may not be for everyone, it reflects just how powerful options as an asset class can be. We have a couple of these trades on the books right now – so its not theory, this is for real
The risk of not knowing
Here’s an interesting thing – the above may be something that you have not heard of before – or perhaps you have heard of it but not really done anything about it. This is why education is such an important thing – learning about what opportunities are really out there. But then it’s not simply about education, its also having the confidence to apply that knowledge – afterall, knowledge alone is not power, it is simply knowledge!
What about Options on CFDs?
Interesting concept!! Covered calls is a time tested strategy – it works – look at the chart here, to see a comparison of the Australian Share Market vs the Buy/Write or covered call index and you can see just how time tested it is.
So why mess with it?
Covered calls require you to buy the stock and then sell options over it – something that means that you need some cash – and if you are short of funds, may be an obstacle. As such, a few out there say “no problem – use CFDs instead” – well – it is a problem – a big one, and here is why:
Part of the reason why covered calls work, is that they are a low risk strategy. Replacing an underlying stock with a geared instrument as collateral – in this case a CFD, which has 10x leverage may sound very sexy – but be careful with this agent provocateur! It will come back at you with all the venom and destruction of a Spring Taipan that has just been stepped on!!
If the value of your shares drop by 5% – which is really very little in the big scheme of things, the value of your CFD account has just been torched to the tune of 50% ouch – I hear you say. That is based on a 5% fall – lets look at Newcrest – who’s shareprice dropped by 35% – that is 350% on the CFD – and hearing that, ouch is probably not the word that springs to mind. MARGIN CALL or something else does…
Yes but the risk management…
So the antidote for our Covered Calls on CFD spruiker – “buy some puts to insure your CFDs”. Again, sounds very enticing – de-risking the trade but let’s explore this beyond a simple statement like “that’s why we buy puts!”
How much are you going to pay for your Puts?
Hmmmm well firstly – what level of insurance do you want? If you want to insure your stock/CFDs for the price you paid for them, then it is going to cost you money – can you offset this by selling Calls?
Not really – because you sold calls “out of the money” – and therefore the premium you earned will be less than what you pay out for insurance, which will cost more as its at the money.
Alternatively, if you sold calls at the money, then the two would balance out and pay for each other, but now you have no income and no upside/nor downside in the stock, so why are you holding the CFD???
What about if you get cheaper insurance?
Yep – insuring your CFDs at a lower level than you paid for them – that makes sense – say 5% lower? Well given the 10x leverage means you will be down 50% on your account BEFORE the insurance even kicks in, then of course there is the cost of the insurance to add to your losses there too, which will need to be deducted, offsetting any income you made from selling the calls!
Ok so I get in, let the stock run up, and then put on my options trades
Congratulations, you are now speculating and worst still, speculating with leverage! Probably not what you are wanting to do, I would guess! What happens if the stock drops and you held off selling calls, and buying puts, and you are using 10x leverage…ARGGGGHHHHHHH
By the way, did I mention that while you are getting put through the mangle, expecting to generate income with this, you are in fact busy trying to fight off risk from all angles, and paying interest on the way through for the privilege!!
An alternative to the “strategy” of selling calls over CFDs with more professional Options Trading Strategies
Instead, we use options to help mitigate the risk and leverage. If you can’t afford the stock, buy a long dated call option. The risk is limited right off the bat as what you paid out ie there is an inbuilt guaranteed stop loss on the trade. What’s more you can select a leverage factor that suits you and, even if the trade goes a little against you, you have time on your side ie you can weather short term volatility without a dreaded MARGIN CALL!!
What’s more, each month you are selling calls, you are generating income which can either be taken as income or used to offset the cost of buying your long dated call, leaving you greater upside. Given that it is long dated, time decay is not a great factor here either.
This is called a diagonal spread – and represents and alternative for covered calls, for those that cant afford to buy the stock – it is more risky than good old covered calls but MASSIVELY LESS risky than selling calls over CFDs. Being more flexible, with a leverage that you are comfortable with, and not requiring insurance on the position, nor any interest to pay – well come on – it makes a lot of sense, right and hence underlines yet another plus for options versus other form of leverage out there – both in terms of flexibility and in terms of risk. Want more information on our Options Trading Strategies – click here
So does this mean options are or aren’t risky?
It is not the instrument, it’s how we use it, that determines risk. Use it professionally and with the right knowledge, skill and respect, then the answer is no, they are not risky. Sell naked positions with options or sell calls over CFDs and yes it would be considered risky.
This comes down to your choice
The choices we make define the risks we expose ourselves to. Smart, informed or educated choices tend to be a lot safer than those that sound enticing and a quick way to get from A to B, all in a shiny and alluring box. That said, all that is fast and shiny doesn’t have to be dangerous, depending of course on your choices.
What is Red, Shiny and as safe as a Volvo!
This week, I received an invitation from American Express, to go for a viewing and then test drive in the latest Ferrari 458. Let me tell you now, even if you are not a car enthusiast, that vehicle will get your pulse up and running.
It looks awesome, drives fantastically and, most importantly is just as safe, if not more so, than many other vehicles on the road today. The point here isn’t simply the car, it is also the driver, and trading instruments are exactly the same.
0 to 100kmh in sub 4 seconds is way beyond my driving skills set – were I to try it – in the wet, on a public road and let’s throw a lamppost in there for good measure – well you can guess the outcome. Airbags and seatbelts or not, there is only one outcome there. The same could be said for your trading account on 10x leverage, so probably best not to have that life lesson either.
Having said that, the one clearly dangerous thing about the 458 is that your neighbours’ may start to “dislike” you. One of the settings – that is recommended you don’t use – is the Manettino button – where all the electronics are turned off (traction control, smart suspension and gear box optimisation etc). It’s all a bit like Alice in Wonderland – “Don’t set the switch to that” – what would you do, being male and being told that?
So, “hypothetically” if you were to use that switch, it unleashes an absolute beast – and what’s more, at about 7000rpm, generally interferes with the TV signals of anyone within a couple of hundred meters – but gee it sounds amazing!!
Looking at the positives and with safety and risk management in mind, I suppose it’s a great way to avoid the distraction from driving and need to call your loved one, to tell them you are almost home – they already know, they can hear you coming from around 2 kms out!!