How Option Strategies Can Be A Great Substitute For Bonds

Introduction

The coronavirus crisis has pushed conservative investors into so-called "safe" assets like bonds and gold, but the real question is whether that makes sense. Can we find better opportunities that result in lower volatility and higher returns? Since the beginning of the year, TLT (20-year US treasury ETF) has had a realized standard deviation of 14.1%, while gold's performance was far more consistent with 11.5% volatility on a monthly basis as per Portfolio Visualizer. Both products remain on track to maintain their double-digit price gains for the remainder of the year.


We utilize options in conjunction with buy-and-hold positions, so the question becomes: can option sellers also opt for bond-proxy strategies? And what about the market conditions we should consider before putting on those positions? Do these trade opportunities only arise in high implied volatility environments, or should we wait for strong volatility contraction? And what about duration: is it for the short-term investor or can the position remain unchanged for a longer period of time?


Before we move on to the meat and potatoes of this article, I'd like to make a couple of statements. I've recently read an article on a Belgian website calling ETF investing the way to go if you want to invest safely. Options were defined as risky products; not for the average/defensive retail investor.

Well, since October 2018, the website's buy and hold portfolio (with new ETF purchases made each month) has produced a negative total return of 6% as per May 10. Guess what? In-the-money covered calls on individual positions (based on our premium report watchlist) would have yielded at least 7% per annum with 40%-50% less volatility. This does not include specific management techniques, just entering the position and evaluating it at the end of the 12-month period.


Why do so few investors utilize in-the-money covered calls as a defensive tool to generate predictable profits? First of all, it's capital-intensive and it's very hard for most retail investors to invest between $15,000 and $20,000 in one position (sometimes up to $40,000). Secondly, popular belief suggests all option strategies are risky given their multiplier of 100. Per each one lot, you are talking about 100 shares of stock. Putting on too many undefined/naked positions might seem capital-efficient (you don't have to put a lot of capital), but when the **** hits the fan, fast and unprecedented losses will blow up in your face. That's why covered positions work best for conservative investors who have the capital to do it. Now, it is true that options can be utilized in a specific way so that you enjoy the same directional exposure as someone owning 100 shares directly. We're then talking about long-term LEAPs to spice up your returns. You can find a step-by-step playbook in this article on Microsoft.


That being said, let's take a look at two main defensive strategies we have studied and for which various calculators have been created: in-the-money covered call writing (9-12 months) and complex strategies (12 months). What do they have in common? What are the advantages and disadvantages? Let me introduce you to the defensive strategy toolkit that the Option Generator community can rely on.


In-The-Money Covered Calls: A Pure Short Volatility Play

When volatility is elevated, options are expensive on an absolute basis. A simple in-the-money covered call is the most straight-forward way of applying option selling in a defensive manner. I have already dedicated numerous articles to this topic, but I'd like to repeat the crucial aspects once more.


The advantages boil down to one key parameter: probability of profit.

  • By selling an in-the-money call with 9-12 months until expiration, we lower our breakeven significantly (in fact, we can determine the 'make-or-break' point for each strike beforehand).

  • Consequently, the lower our breakeven, the higher our probability of profit. The next relevant question we have to answer is how much bang we get for our buck.

  • In this high VIX environment, you can reduce your total breakeven point by 15%-20% and enjoy an annualized maximum return of 12%-13% as shown below with Crown Castle. High implied volatility offers opportunities to transfer some of your assets/liquidity away from monthly covered call writing to defensive, longer-term positions. For more information, I'd like to direct you to this article with American Tower.

(Source: Option Generator)

  • Less volatility in your P&L because of smaller long delta. When selling a call option, we get short delta that offsets the 100 long delta of 100 shares of stock. As a result, selling an in-the-money call with a short delta of 70 results in a total net delta of 30. If the stock price goes up 1%, we generate 0.30%. Looking at the graph above, the inclination of the line depicting the covered-call write strategy is significantly less steeper than that of a simple buy-and-hold approach.

  • It also doesn't take a lot of time to manage your position. Enter the trade, wait and evaluate at the end of each month. For more information, please read our previous article.

There are a few disadvantages to in-the-money covered call writing, but in reality proper risk-analysis will easily overcome these hurdles. I wouldn't actually call them issues, rather opportunity costs if things turn out to be much more favorable than we had initially anticipated.

  • The maximum profit is limited by the strike price. This is the main reason retail investors don't sell covered calls; they want the highest possible returns courtesy of greed. I want to point out, though, that by looking at your entire portfolio we can tweak our directional exposure. In essence, the combination of different strategies creates opportunities and flexibility. If we're worried about the overall market (Covid-19 and economic/corporate profit forecasts), capping your upside potential in return for better chances of success should be of little concern to us.

  • In-the-money covered call-writing is by far one of the most underestimated strategies out there. Generally speaking, investors are incentivized by fast and huge (but non-recurring) profits. In-the-money covered call-writing is about collecting a constant amount of time value (maybe $2 per day per contract), a steady cash flow process which requires discipline and patience. Stated differently, no home runs in the short term.

  • We're short volatility, meaning a spike in the VIX will lead to higher option prices. That's not a positive! We, therefore, put on in-the-money covered calls when the implied volatility is surging. During the latest melt-down, in-the-money covered calls actually lost more than buy-and-hold investing at some point, as described in this article.

Complex Strategies: Setting Up Pairs Trade in Normal/Low IV Environments

Expanding our strategy arsenal into multi-geared tactics (covered calls with other legs), I've created a calculator which simulates the returns for every options construction at various dates, for various stock prices et cetera. Why? As mentioned above, entering in-the-money covered calls works best in a high implied volatility environment. But what to do in normal/low volatility circumstances, if we want to enjoy less volatility in our P&L and a wide profit zone? Complex strategies and in-the-money covered calls form the ecosystem for the defensive part of our portfolio. Because of elevated VIX readings, we primarily favor in-the-money covered calls. Nonetheless, some stocks are worthwhile checking out, namely VEEVA and ALIBABA (see IV chart below).

(Source: MarketChameleon)


Assuming normal implied volatility for these two names and just for illustrating purposes, a combination of a bullish strategy on VEEVA and a bearish/neutral one on ALIBABA is expected to yield the following returns (at expiration). Let me re-iterate that we enter these positions in normal/low volatility environments.

(Source: Option Generator)


The following graph depicts the returns for a neutral strategy on ALIBABA.

(Source: Option Generator)


Excluding the covered call leg (making the strategy considerably less capital-intensive), we get the following outcomes.

(Source: Option Generator)


Just doing the covered-call write on ALIBABA will yield the following results.

(Source: Option Generator)


The detailed explanations of the complex strategies are exclusive to our premium members (highlighted in the monthly portfolio management webinar and other videos), but let me highlight a few aspects of these strategies:

  • Two stocks that form a hybrid strategy

  • Looking at correlation & technical analysis is crucial

  • Entered for 10-12 months

  • Benefit from increasing implied volatility

  • Flexibility: rotating into other strategies when reaching a certain profit target. Switch to in-the-money covered calls if the VIX goes up significantly.

  • Less volatility in our P&L, wide profit zone and high likelihood of outperforming the buy-and-hold investor (as shown below).

  • Assessing directional exposure via the portfolio manager (on a monthly basis).

(Source: Option Generator)


Covid-19 Crash

In case of a crash, what will happen to our complex strategies? I've simulated a neutral complex strategy on SPGI, S&P Global (including the covered-call write leg). At order-entry, one would generate the following returns at expiration (12 month duration).

(Source: Option Generator)


As we all know, the Covid-19 crash impacted nearly every stock, including SPGI. Surprisingly, because of the spiking VIX index we actually achieved consistently positive returns. Below you have some reference points during the decline and subsequent recovery (starting on January 1 up until May 10).

(Source: Option Generator)


Conclusion

Buying ETFs and praying for a happy outcome is NOT the go-to strategy. Simple and complex option strategies tailored to the needs of wealthier investors are so much better than buy-and-hold investing. While it is correct that some strategies are risky because of the leverage effect (multiplier of 100) , covered positions can be crafted to high-probability and risk-defined trades regardless of what kind of IV environment we're living in.


In this market environment, selling in-the-money covered calls for the next 9-12 months will lead to a far better risk/reward profile.

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