This article will highlight some conservative option strategies that have far less risk than simply buying 100 shares of your favorite stock or ETF.
Outsiders often mislabel options as risky and speculative investments.
The irony of this is twofold.
Firstly, originally options were designed for hedging purposes.
Secondly, investors have numerous options structures that are far less risky than simple buy and hold investing.
Let’s get started.
Contents
- Defining “Conservative” Strategies
- Covered Calls Are Not Conservative
- What is the Most Conservative Options Strategy?
- It’s All About the Correlation
- What Should be my Max Loss for a Position?
- The Illusion of Conservative Investing
- Concluding Remarks
Defining “Conservative” Strategies
There are numerous ways to define conservative strategies.
How conservative a strategy is depends a lot on how the position is managed. Position sizing is also important.
Sized too large, a conservative position can still be riskier than an aggressive position sized smaller.
For the simplicity of this article, we will look at conservative options strategies through the scope of defined risk.
Defined risk allows a conservative investor to set a maximum risk tolerance for every trade and avoid the tail risks of some trades.
Covered Calls Are Not Conservative
In searching for similar articles, it was shocking the misinformation suggesting that covered calls are one of the most conservative options strategies.
This was written in numerous places, even most surprisingly, mentioned in an article on Investopedia.
This opinion is also propagated by some investment “professionals” who are not overly involved with options.
While it is true that a covered call has less risk than simply owning shares, the risk reduction is minimal.
The account holder still has unlimited downside risk on the shares.
In return, they only receive the call premium in compensation.
The worst-case scenario is not that the shares get called away (as some suggest) but that the stock goes to zero.
Think about people selling covered calls on Lehman Brothers or Bear Stearns in 2007, how did that conservative strategy work out for them?
This is not meant to bash the covered call as they can certainly be effective.
Although a covered call is simply the same as selling an in-the-money put, defining it as a conservative options strategy is a stretch.
These 5 options strategies below all have far less risk.
1) Protective Puts/ ITM Calls
A protective put is a long out-of-the-money put purchased on a long stock position. A debit is paid for the put and max loss coincides with the distance between the current price and the put price + the debt paid.
This position is the same as simply buying an ITM call.
Naturally, a protective put is more conservative than a covered call as covered calls have undefined tail risk.
Also as implied volatility generally increases when a stock price falls the long exposure to gamma and vega often work to partially offset losses.
2) Short Butterfly
A short butterfly is a risk-defined strategy where an investor sells an at-the-money straddle while simultaneously buying an out-of-the-money strangle.
This allows the investor to express the view that they feel implied volatility is overpriced.
While expressing this view could be done simply with a short straddle that leaves the investor with undefined risk.
By buying the wings an investor can set a max loss for the trade.
3) Long Butterfly
A long butterfly is simply the opposite of a short butterfly.
An investor buys the at-the-money straddle and then sells the out-of-the-money strangle.
This allows the investor to express the opposite view of the short butterfly.
This is the view that implied volatility is under-priced. In this trade, the max risk is simply the debit paid.
Though unlike the long straddle the debt is reduced by selling the OTM wings.
This will result in less variance in the return of the strategy while possibly missing out on an infrequent oversized gain.
4) Verticals/ Credit Spreads
Both credit spreads and debit spreads allow investors to take directional views on the prices of underlying stocks.
Unlike shares, their risk is limited to the debit paid (for a debit spread) or the spread – credit received (for a credit spread).
Tight verticals with longer days to expiry will have very little exposure to greeks other than delta. These are often referred to as digitals.
5) Calendar Debit Spreads
A calendar spread is one of the most conservative spreads an options trader can place.
An investor sells a near-dated ATM option then subsequently buys a further dated option at the same strike on the same stock. By placing this trade, the investor pays a debit.
This also coincides with the max loss of the trade.
This debit is the cost of the additional extrinsic time value of the option.
Being short the front contract and long the back contract will result in an often muted daily P&L.
This position is primarily designed to express a view that forward volatility (between the short and long contracts) is under-priced.
Risk = Defined, Vega (back contract declines in implied volatility & extrinsic value)
What is the Most Conservative Options Strategy?
We now have risk-defined structures to trade long and short volatility as well as trade directionally both long and short. So which strategy is the winner?
Let me explain why there is no single golden strategy or silver bullet.
It’s All About the Correlation
As a conservative investor, sizing positions small and having limited risk strategies are only part of the equation.
If all these strategies are attempting to take advantage of the same risks, they will all be correlated.
As an example, a portfolio with 50 short butterflies will still have significant macro volatility risks.
Even if each position is sized small and has little risk, the cumulation of these positions can make a portfolio risky.
The way to minimize this risk is to diversify across strategies.
For example, that same investor who sells butterflies across stocks will significantly decrease their risk and volatility by adding a few long butterflies.
This is like an investor who buys one stock and shorts another. It becomes a relative value trade.
The importance is not only choosing different strategies but choosing across different strategies that are less correlated.
That ensures that the portfolio has both a low idiosyncratic and macro volatility risk.
What Should be my Max Loss for a Position?
Using defined risk allows conservative investors to set a maximum allowable loss for each position.
By adjusting strikes and position sizing an investor can select the exact risk tolerance acceptable for them.
There is no magic formula for a max loss, though over-betting (even with a positive expected value) can lead to bankruptcy. Having a set max loss may make sense.
Despite this some investors will have greater risk tolerances than others and taking more risk may make sense based on individual circumstances.
An 18-year-old investor with $5,000 betting 5% of his account on a trade is negligible, while someone nearing retirement with a seven-figure account doing the same is a substantial bet.
Having a set max loss but allowing different sizing up to that value can also be smart as it allows investors to size differently based on the perceived expected value of a trade.
The Illusion of Conservative Investing
Some options strategies, aside from covered calls, have the illusion of conservative investing.
Imagine the delta 10 strangle.
This is viewed by many as an easy income trade. Sell a small premium, collect it, rinse, and repeat.
These strategies have a high percentage of profit hence are often touted as conservative strategies.
They also normally have very stable returns and low volatility.
But are they really that conservative?
Left unhedged these strategies can cause an investor to make money for years on end only to blow up spectacularly in a market meltdown.
Ever heard of the saying picking up pennies in front of a steam roller?
Investors can trade these strategies, even have a positive expected value, and still blow up.
This is simply due to tail risk.
Strategies such as the wide naked strangle can be implemented as part of a conservative portfolio but only if at a certain point it is delta hedged.
Nobody should hope the index goes back up after your delta 10 put is now a delta 80.
Conclusion
The unique thing about options is they allow an investor to express the exact view they have.
This allows you to get the precise exposures and risks that you want while avoiding the risks that you don’t. Many options structures such as the butterflies, verticals, and calendars offer conservative investors unique opportunities.
This allows them to access defined risk trades that are unattainable without the use of options strategies.
The multiple ways investors use options to hedge and take on selective risks make them incredibly versatile in their use for low variance, conservative portfolios.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
Some pertinent points made in this article.