The well-documented influx of new retail investors into equities and options on equities in 2020 and 2021 has boosted derivatives volume, but it also has unleashed traders who may not be prepared for high rates of volatility if and when the market falters.
In an interview with JLN, finance professor Edward Szado urged novice traders to learn the ins and outs of options trading and investing before they dive into the market. “The first step before trading a single option is to go to the free websites of the OCC and OIC (Options Industry Council) and learn more about them,” he said.
Szado, who teaches finance at Providence College in Rhode Island, is also the research director for the Institute for Global Asset and Risk Management (INGARM), an educational foundation.
“Options are fabulous, but (there are) so many characteristics that you need to know about them,” he said. “You need to understand their non-linear nature and the Greeks (which are ways to measure the factors that impact options prices), particularly delta and gamma,” he said.
“I would never recommend going into the market blindly,” Szado said, but he acknowledged “buying options is potentially safer than selling options.” Why? “You can potentially lose 100 percent of your investment (with an options purchase), but it’s limited to 100 percent of your investment, whereas with naked selling of an option you can lose more than 100 percent.”
“The devil is in the details,” he said.
Institutions vs. retail investors
Looking at the options markets through an institutional lens, Szado said his research shows that funds that use options in combination with positions in stocks and bonds have generally performed better than with a strategy that excludes options.
“However, a lot of retail customers use options for purposes different from what I am talking about,” Szado said. “For example, using a call option just to get upside exposure to an equity with leverage — that’s very different from the way most institutional investors use options.”
The benefit of options is that they allow you to tailor the return distribution of a portfolio to fit your particular risk tolerance return needs, he said. This can also be done with levering and delevering, but Szado said it can be done more selectively with options. “I am talking about options strategies from a return-enhancement or risk-mitigation point of view,” he said.
For example, a 2 percent out-of-the-money 1-month buy-write strategy is a return enhancement strategy that generates income through the writing of an option every month. That involves buying the underlying and selling the call a couple of percentage points out of the money. The upside for the strategy would be 2 percent, but every month the investor collects a fixed premium plus the capped underlying return. It’s a way to get extra income in a sideways market or slightly lower market, he said.
Szado was a guest speaker at a recent Cboe Options Institute seminar on options strategies in the current low-interest rate, high-volatility environment. He said a traditional 60/40 stock/bond portfolio model is limited under those conditions. “It’s really hard to get any sort of reasonable yields on the bond side…and we traditionally think of the bond side as being the low-risk part of the portfolio.”
“If rates were to go up — and you can’t really imagine them as going down much further right now .. you’d have some serious losses with a 20-year-duration portfolio,” he said. “There is a lot more risk on the bond side than we are used to seeing.”
He noted that ahead of the 2009 financial crisis market participants relied on diversification to mitigate risk, “but all the correlations went to one” — that is, everything went down together. “One of the benefits of using options to control your risk is that you are not simply relying on historical correlations for diversification, you can be protected even if they go to one,” he said.
Szado said his research has involved looking at both equity index vs. options, 60/40 portfolios vs. options, and a fully diversified endowments vs. options portfolio. “Typically options can have meaningful impacts on the risk of the portfolio across the board,” he said, “and return enhancement using a buy-write strategy can be helpful as well.”
Risk control as a goal
While there are numerous options strategies, Szado outlined a couple that illustrate risk-control basics. For example, a collar strategy is a popular trade used to mitigate risk. Simply stated, it involves determining the level of risk the market participant is comfortable with, and once it is defined, adjusting the collar to match. In practice, a collar involves holding the underlying (the S&P 500, for example), purchasing an out-of-the-money put on the S&P 500 to place a floor on the portfolio, and selling an out-of-the-money call to help pay for the out-of-the-money put.
How far away the call and put are from the current price will determine the range of risk, or the portfolio value that can be lost or gained. The collar can be wide, allowing the investor to move up or down a lot, or narrow with a more limited range.
The investor can also use a put-spread collar, which is less expensive but only provides a buffering of losses, not a floor, resulting in less protection than a collar.
Using options, you can also execute a strategy similar to a 60/40 portfolio strategy without the bonds by putting a collar on the equities and reducing the volatility without having to lock into a virtually zero bond yield.
Given the potential level of risk in the market right now, collars and put-spread collars are currently popular risk-mitigating strategies, he said. Again, “The investor gives up a little bit of the upside for protection or mitigation on the downside.”