In times of high volatility, options are an incredibly valuable addition to any portfolio as part of a prudent risk-management strategy, or as a speculative, directionally neutral trade.
After a trader has conducted their due diligence and enters a position, regardless of how certain they may be of the direction a volatile stock will take on, they are very much limited to the ebb and flow of the market and its participants. A prudent trader may have a risk management strategy in places such as portfolio diversification, a tight stop-loss order trailing their position, or a mandate to average down (or up) in case the stock makes a move against them.
However, there are some important drawbacks to these strategies: diversification may take up precious amounts of capital away from other ideas, stop-loss orders may trigger shortly before the asset goes the way it was anticipated from the beginning, and averaging down/up can take on inordinate risk as the position continues to go awry. Armed with the knowledge of options, traders can expand their risk management tool-set, and subsequently, increase the potential of returns on their positions.
Synthetic Stock Positions
One of the main ways that an option can mitigate risk is through its inherently leveraged nature. An astute options trader can take this one step further and create synthetic long and short stock positions entirely compromised of options. By going long with an at-the-money call, and writing an at-the-money put, the options trader can simulate a long stock position. Moreover, by writing a put option to counter the call option’s premium, the trade can be opened with little or no initial cost.
As the underlying stock rises, the call increases in value, and should the underlying stock plummet, the short put will increase in a value, and thus, the trader will take on downside losses, much like an actual long stock position. Conversely, a synthetic short stock position would be initiated when the trader buys a put and sells short a call.
The benefit that a synthetic stock position presents during times of volatility is the ability to control large volumes of shares with little to no capital tie-up, thus allowing traders with even small accounts to take on diversification measures. Furthermore, the synthetic positions offer more flexibility to exit the position through the purchase of a contrasting option: a put option for the long stock and call option for the short stock positions, as opposed to having to pursue a mandate to average down/up. Finally, synthetically shorting a stock has the added benefit of allowing the trader to short hard-to-borrow shares, not have to worry about borrow fees, and be unaffected by dividend payments.
How To Trade The VIX
The Protective Put
Options can also be used to protect an existing stock position against an adverse volatile movement. The simplest and most commonly used options strategy is the protective put, for a long stock position, and the protective call for a short stock position.
Let’s take a look at a stock known for its volatility: Tesla Motors, Inc. (TSLA). With the stock trading around the $185-$187 area in early March 2015, a bullish trader could go long in this position in the hopes of a quick swing to $224 level and purchase a $190 strike put option expiring on April 17th for $8.05 or $805. The trader will thus enter the position fully aware of the maximum loss that can be incurred on this trade from the day of purchase until option expiry, which would be the put’s premium plus the distance from the strike of the put to the entry price.
Tesla closed at $193.74 as of mid-March 2015, so that would be a max loss of $11.79 per share or roughly a 6% loss per each 100-share position worth $19,374. Put it another way, from now until April 17th, regardless of how far down Tesla plummets after breaking support, the trader will always be able to exercise the option on expiry to sell off his shares at the strike price – even if Tesla drops by $1 below the strike or all the way down to zero.
Furthermore, if a trader has already experienced gains on a position, and as volatility looms on the horizon, such as it did on the days leading up to Tesla’s unveiling of the Model D, the trader can use some of their profits to lock in their gains by purchasing the protective put. The downside to this strategy is that a stock will need to move in the anticipated direction, and the option premium will need to break even. And should the stock not make such a move between now and the option expiry, the put options can expire at zero dollars due to the ravages of time decay (theta), without ever having been exercised.
In order to combat a potential loss of premium, the trader can simultaneously write an inverse option to the protected put or call. This strategy is known as the collar, and it can serve to mitigate the protective option's premium outlay at the cost of putting a cap on future gains. However, collars are an advanced strategy, beyond the scope of this article.
Perhaps the most advantageous characteristic of options over a pure-stock position would be the ability to employ directionally neutral strategies that can make money on a stock no matter which way it goes. As an extremely unpredictable moment approaches, such as an earnings report, a stock trader is limited to a directional bet that that is at the mercy of the markets.
However, an options trader will welcome this impending volatility by going with long straddles and strangles. A straddle is simply the purchase of an at-the-money call option and an at-the-money put option with the same strike and expiry date. It is a net debit transaction that a trader enters in should they expect a large move in either direction in the near future. By examining the historical versus implied volatility (IV) and expecting higher the IV in the future (such as when an earnings report date approaches), the trader can enter the straddle position, knowing full well the maximum loss they can incur is the net premium they paid for the combined options.
On the contrary, if a trader assumes that volatility levels are simply too high, the options are mid-priced, and subsequently the stock will not move as much as the market expects in the near future, they can sell straddles or strangles, taking advantage of the phenomenon known as the “IV crush.” Directional neutrality is perhaps the biggest weapon in an options trader’s arsenal, and it is the foundation for more advanced strategies such as butterflies, condors, and delta neutral trading. By being directionally ambivalent, the trader has conceded that the markets are random and has positioned themselves to make money both as a bull and a bear.
The Bottom Line
Options offer lower levels of capital outlay, a myriad of strategies that are directionally biased or neutral, and excellent risk management properties. While there is nothing wrong with trading pure stock portfolios, by arming themselves with the knowledge of options and their characteristics, a trader can add more tools into their arsenal and increase their chances of success in both volatile and docile times within the markets.