Incorporating options into your investment strategy

[Lemur]

I’m curious if anyone here utilizes stock options and how you incorporate them into your overall investment strategy.

I incorporate them for accumulation phase purposes.

For a while I was doing covered calls and getting fantastic savings boost until I felt hands-on the drawbacks (I gave away too many gains which was a shame considering I bought the right stocks at the right price and at the right time). I just switched over to using vertical call spreads with the aim to close out the spreads at 50% max profit. In my portfolio, I am aiming to have no more than 10 unique stocks and I am slowly working to only have a 5-8 stock focus. Growth is the goal and any stock that is not growing for me will be dumped.

I have to imagine once I reach the 25-33x expenses net worth, I may begin to use options differently. Such as buying puts on overvalued positions.

This had me thinking if one needs a 7% growth rate to maintain financial independence, one could simply divert some investment returns on stocks >7% growth on puts to maintain principal overtime. If a sudden downturn occurs, one is covered.

Then there is always speculation such as trying to luck out on black swan events by purchasing far out of the money Calls or Puts. Or even risking your assets with naked options (I personally do not recommend but then again I’m not a professional trader).

[Mister Imperceptible]

Have gone from <18x expenses to >45x in 6 months by being long vega and long gamma. This would have a been a disastrous strategy for most of the previous decade. It is possible my timing is attributable to luck. When confronted with the idea that he was merely lucky, Napoleon responded “Give me lucky generals.”

My edge, if it is an edge and not a delusion, is having seen volatility in the near term as inevitable where others consider it some aberration that will subside.

Would hate to be short gamma especially as election approaches.

If one needs a compounding 7% annual growth rate, my guess is that the strategy that yields 50-100% or more in one year amidst a string of years with no returns or small losses with outperform (with less risk) a strategy that targets a specific yield and reaches for that yield every year.

Going off what people smarter than me have written. Plus intuition.

[shemp]

When seeking above average returns, first step is identify dumb money which will be getting below average returns, and explain why smarter money than yourself isn't already targeting this dumb money, and why you aren't dumb money to those smarter than yourself.

Beating the markets is by no means impossible, or even that difficult. But unless you can answer the questions in the previous paragraph, outperformance is more likely luck than skill.

Most common way to beat the market is to first suffer below average returns for several years, followed by extreme outperformance, as MI suggests. Hedge fund smart money cannot do this because their clients will not tolerate below average performance for years on end, and especially clients won't tolerate 2+20 management fees for a fund that goes all cash or all t-bonds for years on end. Your only competition is thus Individual smart money. However, most smart individual investors are like me: old and retired from the game, more interested in preserving than growing wealth, and thus no longer acting like smart money. Avoid strategies that play out over periods shorter than about 4 years, because that's the domain where hedge funds can safely operate without losing clients. If strategy takes less than 1 year to play out, competition is particularly ferocious, including computer driven trading. You do not want to compete against Renaissance Technologies.

[Seppia]

I intuitively align with shemp, and would add that anecdotally, all the people I know whose main trading was around options have sooner or later suffered an event where they gave back all their gains and then some.

[shemp]

Usual problem with options is that professionals or hedge fund take the other side of the trade, and you need to be really smart to beat them, at least with short run (under 1 year) strategies. There are rumors that the Robinhood crowd has swamped the option market lately, and neither professionals nor hedge funds have the capital to keep up with the craziness. So possibly there are some lucrative but low risk opportunities out there. Professionals and hedge funds will eventually move in, so don't expect the situation to last long.

[jacob]

TANSTAAFL!

Options market makers(*) (GetCo is/was the biggest one) have achieved (random walk) "efficiency" for at least the price of the underlying and delta. Thus option competition is between different models (EMA, GARCH, vol surfaces,... and fancier) for vol under the assumption that the underlying is random AND those who still use the options for their original intention, namely speculation or insurance. IOW, the competition is happening at gamma and higher greeks.

(*) Market makers will make most of their money on the spread. They will generally try to neutralize all their greeks. Note that when I'm say market makers, I don't mean in the legal sense that they have to stay in ... more like they're almost always quoting a bid/ask. However, if someone moves against them by e.g. beginning to buy up a large position (lift the ask), they'll respond by moving the ask up and up and up and so on. Most single-issue options are not nearly thick/liquid enough to absorb large amounts of volume and hedge actively, so instead makers increase the spread or pull out entirely to curb the enthusiasm.

You can not compete (extract a rent) with the former. That is, if you use a covered call strategy ATM as an additional cash stream, it's not free money. Rather you're converting positive vol into a cash flow at the market rate. In this world of zero commissions that might actually not be the worst thing since you'll significantly smooth out your portfolio value insofar you're into that.

To actually make money, you have to have a speculative/directional strategy, that is, you have to know something (add information to the market). In my case, I use options to exit a position when I think it's overvalued. An alternative to that would be a stop limit. The near-term price trend determines which is better. EMA, GARCH, etc. would not know about nearby trends, so this would be a case of adding information to the market. On the flip side, this is competing against speculators who definitely know more than me.

TL;DR - Market makers "lock" the option pricing to the underlying using fairly robust random walk models. (More advanced than your standard stuff, but still mathematical in nature.) You'll only profit if you're adding speculative insight. You can not beat these guys on financial engineering strategies. That does not mean that engineering might not be useful to your portfolio management strategy.

[Lucky C]

This had me thinking if one needs a 7% growth rate to maintain financial independence, one could simply divert some investment returns on stocks >7% growth on puts to maintain principal overtime. If a sudden downturn occurs, one is covered.

I suggest shifting mentality from thinking an idea could work by default to why an idea couldn't work by default. Investment strategies should be guilty until proven innocent. When I started investing, my weakness was that I would jump into a strategy with an understanding of how it could work, without understanding nearly as well how it could not work. Now I have found that my current investment strategy should almost certainly work after studying all the ways I (or others) could come up with that it might not work. I speak generally, not specifically options trading.

So your task is to figure out why doesn't everyone just use the quoted strategy to retire with a 7% SWR rather than a 3-4% SWR? That's quite a significant loophole you've discovered, and would be well worth the time to prove to yourself that it can work, or prove to yourself that it can't work so that you don't try it.

Or more importantly, attack the options strategy you are currently using with every idea you can come up with for why it may fail to beat the market. If you can prove your strategy innocent, you will not have wasted your time as you will come out with a better understanding and be able to invest with conviction - good for psychological management.

[Lemur]

@Lucky C

Actually what I was getting at there was one would still retire with a 3-4% SWR but, in an active portfolio, as opposed to an index fund, one could use various options strategies to smooth out volatility in the portfolio by using put options to hedge against stocks that have a sudden run-up in growth. 7% was chosen merely for 3-4% growth + inflation.

If I were to retire with a 7% SWR...active trading would become a full-time job to maintain that. Would not be worth it to me.

I get the sentiment though; I've been jumping on strategies. While not the most efficient, they've been good teachers.

[7Wannabe5]

I am not going to use the correct vocabulary, but it is my understanding that an offer made within the breadth of the spread must either be accepted or “published”, so small potatoes might be accepted in order to avoid “publication.” So, this might be an obnoxious way to make money at the fence line of the theoretical future.

[jacob]

@7wb5 - It's possible to post "dark" quotes between the "lit" bid and ask. There is an enormous (like 100+) ways of doing this. This (order type zoo) is generally not available to retail investors (who only have the simple ones like limit, market, stop, ...), but your broker will have access and sometimes try to hit the dark orders to get a better price for you. There can be multiple dark orders sitting between the bid and ask.

E.g. a book might look like this
...
lit bid-9
lit bid-10
dark bid-11
dark bid-12
dark ask-13
nothing-14
lit ask-15
lit ask-16
...
No one but the crossing engine (the computer pairing the trades at the exchange having replaced the shouting people in the pits) would be able to see anything but bid 10/ask 15. Note that some can also post at "midprices". This midprice [order] can be floating! E.g. in the above, the midprice is 12.5. If you post a dark sell order at the midprice and the lit ask at 15 moves down to 14, you'd get filled by the dark bid at 12.

If you submit a market buy, you'd get at 13 by lifting the dark ask. Algos and traders will sometimes go on fishing expeditions posting orders for 1 share at a time. Large dark orders are also called icebergs. Dark orders were invented so institutional traders didn't have to publish their entire order to the world either directly or in some obscure way that traders would try to sniff out and consequently front run.

In practice, as a retail investor, it's always a good idea to see if "there's something hiding" by posting a fill-or-kill order in the middle. If it hits expect the market to go against you. Icebergs are generally a sign that something bad is lurking. In every single case, you will ALWAYS get the best price that the entire market has to offer. IOW, if you do a market order, you WILL get the so-called "national best" whether it's dark or lit or posted on NYSE or one of the other 40+ exchanges/dark pools. Exchange operators have to pay a fine to the SEC if they fail to do this.

Generally, there's a sneaky algorithmic chess game being played inside the spread. This is a big reason why brokers can offer $0 commissions.

[Lucky C]

@Lemur
Ah I see what you mean.
How I would think about this if I'm not trying to "beat the market" and just trying to have a successful FIRE: If I want to retire with a 4% SWR, how would options have helped in the cases that have failed historically? The historical cases involve high inflation causing spending to outrun investment returns of a buy and hold portfolio as in the late 60s / early 70s, or too much of a sharp drawdown in the first few years which might have caused failures if you tried to retire in e.g. 1929 or 2000 (we'll see).

For some people, a buy and hold portfolio with a different allocation than what Firecalc uses (e.g. add international, emerging, gold, etc.) is sufficient to have confidence in avoiding a FIRE failure. However options may be able to get the job done if you don't want to expose yourself to the currency risks of international markets, the volatility and lack of yield with gold, etc. As Jacob said, you may be able to smooth out your portfolio, which will of course come with a certain cost, but you may be able to calculate an optimal tradeoff (for your taste) to limit downside risk while not taking too much of a hit on average expected return.

[7Wannabe5]

@jacob:

What if it’s a covered call way out of the money and way out in the future with very low trading volume? Like one time I did this “trick” and the trading volume was 1.

[jacob]

In that case, one side would be someone who knew something and the other side would be picking up pennies somewhat farther away from the steam roller. Could be any number of reasons, really. Far ITM and OTM options are rarely traded and rarely happen. Also goes for anything beyond the "front-month".

(I've put non-obvious actual terms/jargon within "". Google for more info.)

[Laura Ingalls]

DH uses covered calls to sell positions he thinks he has too much of or that have run up too quickly (i.e. things he would like to sell.). Also calls that don’t get called away and you collect the premium on generate cash without causing an immediately taxable event unlike capital gains or pesky earned income.

[plantingtheseed]

IMO to make real money in options, you have know the future and get the direction and the time frame right like the definition and leverage it.

Barbell strategy sounds interesting. Often vix call can be used this way near possible market breaking points to speculate, like right now.

It tends to be sticky so once the market crashes usually there is plenty of time to get out, etc. But you're bleeding until the payoff and payoff may not happen soon enough or may not be big enough to cover the expense.

People tend to over bet and this is how they usually lose money in options.

It's always better to know the future before making a bet. And this does happen - like on the day when the 2T bailout package was passed. Nothing moved until the next day.

I was certain of the immediate future (up) and I loaded up on BRKB call options (it follows SPY but cheaper) but even then, only bought like 10 contracts out of caution. Nothing is 100%.

How well do you know the underlying? Maybe there is something there.

[7Wannabe5]

In that case, one side would be someone who knew something and the other side would be picking up pennies somewhat farther away from the steam roller. Could be any number of reasons, really. Far ITM and OTM options are rarely traded and rarely happen. Also goes for anything beyond the "front-month".

Gotcha. I was just doing an experiment to find out where the stock market was like the rare book market. I don't really understand the relationship between liquidity and efficiency. I just know that if I am the only dealer selling a certain book then I can set the price and wait for a buyer.

[Dream of Freedom]

I sometimes use them to enter a long term position. I sell an in the money put. I could look up individual trades I've done but I would have to dig up the old stock price too and I'm lazy. So, I'll just find a current example. You can sell a CCL 16.50 August 14 put for .085. The stock price is 16.10. So it's like buying it @ 15.65 or .55 cents off in 3 days.

I also use long options for technical analysis based speculation though I definitely limit my position size. Like under $1000.

[JackMoore1965]

@jacob:

What if it’s a covered call way out of the money and way out in the future with very low trading volume? Like one time I did this “trick” and the trading volume was 1.

nice “trick”

[jacob]

https://www.marketwatch.com/articles/ho ... 1599866516

tl;dr - Zero commissions have attracted small retail players/young app investors into the options market where they can buy exposure for a few dollars instead of needing thousands.