This article introduces some conservative option strategies that involve far less risk than simply buying 100 stocks of your favorite stock or ETF.
Outsiders often mistakenly refer to options as risky and speculative investments.
The irony is twofold.
First, options were originally designed for hedging purposes.
Second, investors have numerous option structures that are far less risky than simple buy-and-hold investments.
There are numerous ways to define conservative strategies.
How conservative a strategy is depends heavily on how the position is managed. The position size is also important.
Overly sized, a conservative position can still be riskier than an aggressive position of a smaller size.
To simplify this article, let’s consider conservative option strategies within the scope of the defined risk.
The defined risk enables a conservative investor to set a maximum risk tolerance for each trade and to avoid the tail risks of some trades.
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When searching for similar items, the misinformation suggesting that covert calls are one of the most conservative option strategies.
This has been written in numerous places, even surprisingly mentioned in an article on Investopedia.
This opinion is also shared by some investment “professionals” who are not too much into options.
While a covered call carries less risk than simply owning stocks, the risk reduction is minimal.
The account holder continues to have an unlimited risk of loss on the shares.
In return, they only receive the call premium as compensation.
The worst-case scenario is not that the shares will be called (as some suggest), but that the stock will go to zero.
Think of people who sold covered calls to Lehman Brothers or Bear Stearns in 2007, how has this conservative strategy worked for them?
These are not intended to beat up the covered call as they can certainly be effective.
Although a covert call is just the same as Selling a put in the moneyDefining it as a conservative option strategy is a stretch.
These 5 option strategies below all have far lower risk.
1) Protective puts / ITM calls
A protective turkey is a long-out-of-the-money put that is bought on a long equity position. The put is charged and the maximum loss coincides with the difference between the current price and the put price + the debt paid.
This position is equivalent to simply buying an ITM call.
Of course, a protective put is more conservative than a covered call, as covered calls have an undefined tail risk.
As well as implied volatility generally rises when a stock price falls long exposure to gamma and Vega often work to partially make up for losses.
2) Short butterfly
A short butterfly is a risk-defined strategy in which an investor sells for the money Slides when buying an out-of-the-money at the same time strangle.
This allows the investor to express the view that he believes the implied volatility is overpriced.
While this view could be expressed, a short straddle could simply be used, leaving the investor with undefined risk.
By purchasing the wings, an investor can set a maximum loss to trade.
3) Long butterfly
A long butterfly is just the opposite of a short butterfly.
An investor buys the straddle at the money and then sells the strangle out of the money.
This allows the investor to express the opposite view of the short butterfly.
This is the view that implied volatility is undervalued. On this trade, the maximum risk is simply the direct debit paid.
In contrast to the long straddle, however, the debt is reduced by selling the OTM wings.
This results in less variance in the return on the strategy while potentially missing out on a rarer oversized profit.
4) Industries / Credit Spreads
Both Credit spreads and Target spreads enable investors to get trend-setting views on the prices of the underlying stocks.
In contrast to stocks, your risk is limited to the direct debit paid (in the case of a debit spread) or the spread – credit received (in the case of a credit spread).
Tight industries with longer days to expire will get very little of it Greeks except Delta. These are often referred to as digital.
5) Calendar debit spreads
A Spread calendar is one of the most conservative spreads an options trader can place.
An investor sells an option at the ATM with a near date and then buys another option with the same date at the same strike price on the same stock. By placing this trade, the investor pays a direct debit.
This also coincides with the maximum loss of the trade.
This charge corresponds to the cost of the additional extrinsic time value of the option.
Short positions in the front contract and long positions in the back contract often lead to a subdued daily income statement.
The primary purpose of this position is to express the view that futures volatility (between the short and long contracts) is undervalued.
Risk = Defined, Vega (reverse contract declines with implied volatility and extrinsic value)
We now have risk-defined structures to operate long and short volatility and directional long and short trades. Which strategy is the winner?
Let me explain why there is no single golden strategy or silver bullet.
For the conservative investor, small positions and limited risk strategies are only part of the equation.
When all of these strategies try to exploit the same risks, they all become correlated.
For example, a portfolio of 50 Short Butterflies still has significant macro volatility risks.
Even if each position is small and carries little risk, the accumulation of these positions can make a portfolio risky.
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The way to minimize this risk is to diversify across different strategies.
For example, the same investor who sells butterflies across stocks will significantly reduce their risk and volatility by adding a few long butterflies.
It is like an investor buying one stock and selling short another. It becomes a relative value trade.
It is important not only to choose different strategies, but also to choose different strategies that are less correlated.
This ensures that the portfolio has both low idiosyncratic and macro volatility risk.
The use of a defined risk enables conservative investors to set a maximum allowable loss for each position.
By adjusting strikes and position sizing, an investor can choose the risk tolerance that is acceptable to him.
There is no magic formula for a maximum loss, although too high stakes (even with a positive expected value) can lead to bankruptcy. It can make sense to have a set maximum loss.
Even so, some investors will be more risk tolerant than others and it may be wise to take a higher risk based on individual circumstances.
An 18-year-old investor with $ 5,000 wagering 5% of their account on a trade is negligible, while someone close to retiring with a seven-digit account doing the same is a sizable bet.
Having a set maximum loss but allowing different sizes up to that value can also be smart as it allows investors to choose different sizes based on the perceived expected value of a trade.
Something Option strategiesExcept for covered calls, the illusion of conservative investing.
Imagine the delta-10 choke.
This is viewed by many as a simple income business. Sell a small premium, collect it, rinse it, and repeat the process.
These strategies have a high percentage of profits and are therefore often touted as conservative strategies.
They also usually have very stable returns and low volatility.
But are they really that conservative?
Unsecured, these strategies can result in an investor making money for years only to blow up spectacularly in a market crash.
Have you ever heard the saying that you pick up pennies in front of a steamroller?
Investors can trade these strategies, even have a positive expected value, and still explode.
This is simply due to the tail risk.
Strategies like the Wide Naked Strangle can be implemented as part of a conservative portfolio, but only if delta hedges are carried out at a certain point.
Nobody should hope the index is after your Delta 10 put is now a Delta 80.
What is unique about options is that they allow an investor to express the exact point of view they have.
That way, you can pinpoint the exposures and risks you want while avoiding the risks you don’t want. Many option structures such as butterflies, verticals, and calendars offer conservative investors unique opportunities.
This gives them access to defined risky businesses that cannot be achieved without the use of option strategies.
The multiple ways investors use options to hedge and take selective risk make them incredibly versatile to use for conservative, low variance portfolios.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.