These Smart Option Strategies Lead To Fewer Capital Losses

Introduction

The coronavirus pandemic has left many investors in big trouble. Hedge funds saw huge outflows and losses because of the brutal sell-off in March. The economic fallout unquestionably leads to an evaluation of your investment strategy. For my wealth management clients, capital preservation (higher probability of profit) is of key importance to build up sustainable long-term investment success. In this article, I'll show you how smart option strategies lead to a favorably skewed risk/reward profile. However, it depends on how much volatility there's pumped into the options premium to decide on what kind of strategy fits the bill.


Fiserv

We recently entered a trade setup in Fiserv on April 3, 2021. First, we purchased 100 shares at $89.54 to initiate the primary leg of the strategy: a covered-call write. Having opted for the at-the-money covered call ($90 strike) expiring in January 2021, we generated $13.10 per share. This results in the following graph (on an annualized basis) at expiration:

A very appealing risk/reward profile given the high implied volatility. However, there's a slightly different strategy which generates even more profits if Fiserv stays within $85 and $93, when adding a second option strategy and utilizing 27% implied volatility as the parameter for the LEAPs we're going to purchase.

If volatility is above 27% in January 2021, the profits could easily exceed those of a traditional covered-call write. With the second leg of the trade, you have to come up with $893 in cash.

If the implied volatility amounts to 35% (because of lingering economic problems, coronavirus consequences?) in January 2021, we generate a substantially higher profit than the one calculated in our base case scenario and the covered call write.

To put another way, increasing volatility has a favorable impact on our profits when entering this options strategy. The return of a pure covered call write, however, is based on the implied volatility at the time of entry.


Simulation with the S&P-500: SPY Tracker

1) Without hedge

Let's simulate these situations when the VIX stands at 20%. The first trade setup I'm going discuss is this one:

* Buying 100 shares of SPY at $278.2

* Selling an in-the-money covered call ($270 strike) with 285 days to expiration for $23.7 per share

* Adding this component to the setup (equal amount of puts and calls, referred to as 'without hedge') for a total cash investment of $1,966.


The following comparison graph appears. (returns as of January 21, 2021)

The in-the-money covered call has the same breakeven point, but between $250 (10% decline in SPY) and $318 (15% increase in SPY) the more complex option setup yields far better returns.

Stated differently, a noticeably better risk/reward profile is achieved when volatility is lower than 20%.

If volatility goes up to 30% (from 20%), your P&L profile improves even more. In a rangebound market, you have an opportunity to generate 28% per year. If the market goes down by 14%, you've lost only 1%.


2) With hedge

If we were to add an additional put to the setup, we now have to invest $5,006. In case you're bearish on the overall market (you want to hedge your portfolio) and volatility is normal/low, this strategy suits your profile.

* Buying 100 shares of SPY at $278.2

* Selling an in-the-money covered call ($270 strike) with 285 days to expiration for $13.7 per share

* Adding this component to the setup for a total cash investment of $5,006.


The following comparison graph appears. (returns as of January 21, 2021)

Just like the first setup, we get a positive return differential of 14% compared to the buy and hold investor. However, since we're short the overall market, we start to underperform a traditional in-the-money covered call write at $292 and a buy and hold strategy at $295 (5% increase in SPY). This is based on the assumption of no changes in implied volatility.


If volatility goes up by 10%, we generate a positive 5% return versus a market drop of 17%. Between $240 and $320, we outpace both the covered call writer and the buy and hold investor.


So, if you're cautious on the market but don't want to miss out an attractive gains in a rangebound market (up to a 5% gain for the SPY), then you can implement this strategy. In case the market goes down by 10%, we can take advantage of increasing volatility, thereby pushing our profits to higher levels.


3) Combinations

A combination of 1/3 without hedge (base scenario), 1/3 with hedge (2 puts being bought), 1/3 in-the-money covered call writing would yield the following returns. These are based on 20% implied volatility and on January 21, 2021.

As you can see from the graph above, we beat the buy and hold investor if the S&P-500 goes up by less than 7%-8% on an annualized basis. If the S&P-500 stays flat, we would generate a return of 11%-13% within the $270-$290 range, noticeably better than just holding onto the ETF strategy. In a very rosy market environment with gains of 20%, the green line would produce an annualized return of 3.5%-4%.


Now, what if volatility surges more than 10%? As one would have predicated beforehand, a 50/50 mix of the complex strategy with and without the hedge outpaces a 1/3 with hedge, 1/3 without hedge and 1/3 in-the-money covered calls. These are based on 30% implied volatility and on January 21, 2021.


This telling chart represents what it's all about: tweaking option strategies to every possible scenario. I'm going to use the 50-50 combination to illustrate what kind of results one would have generated during the coronavirus pandemic.


4) Really bearish market assumption

Before we go into great detail on the coronavirus impact on these strategies, I'd like to present you another strategy. Let's say you are really bearish on the overall market and look for a positive return in case the market collapses or flatlines.

* Buying 100 shares of SPY at $278.2 + implementing this options setup


The following comparison graph appears. (returns as of January 21, 2021)

If the market were to drop 18%, the blue line would produce a positive 3% return with the very same 20% implied volatility. Even if the SPY goes up 5%, we would generate 6%.


Mayday Mayday! Coronavirus Destroys Buy And Hold Portfolios

Let's simulate the returns during the latest market crash. We have four setups.

1) Speaking hypothetically, on December 31st, 2019 we purchase 100 shares of the SPY at $321.86. The IV stands at 14% for the LEAPs. We add the following components to the trade (referred to as the hedge strategy). The expiration dates are utilized for hypothetical purposes.

Always include this covered call leg:


2) The strategy referred to as 'without hedge' is buying and selling an equal amount of puts/calls (so 1 put instead of 2 puts bought) + covered call write

3) The ordinary covered call write (see above)

4) The bearish assumption strategy, which consists of 3 puts, and the covered call write

Below, you find the simulation for a series of remarkable VIX readings along with the steep S&P-500 drawdowns. As expected, the bearish strategy yields impressive results, but the same goes for the moderately bearish hedge strategy. Also, because of being heavily short volatility, the covered-call write does not provide us with downside protection. Frankly, the base strategy still outpaces the buy and hold investor as expected.

Now, looking at a few combinations, I expect the 50-50 combination with and without the hedge to yield attractive returns. This is especially true since no higher volatility or market crash is needed for this to produce juicy returns. Even in bullish market environments, you would still generate 6% with this combination versus 10% for the SPY based on the graphs I've discussed earlier in this article.

Based on sound common sense, this strategy provides you with protection in steep corrections (and the explosion in volatility) while allowing for decent profits in normal/rangebound market environments. Use in-the-money covered call LEAPs (1-year expiration period) when volatility is elevated; turn to the complexer rangebound option strategies when volatility is low. Interested in learning how to utilize these strategies? Become a premium member and start to invest wisely.

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