IS BUYING OPTIONS A WASTE OF MONEY?
This informal CPD article was provided by Options Insight,
experts in providing basic trading fundamentals, live interactive
trading simulations and in-depth derivatives trading workshops.
It’s true what they say, most options do expire worthless. But
does that mean that buying them is a “mug’s game”?
The systematic, risk premium harvesting, carry earning and yield
hunting crowd would certainly answer with a resounding “YES”
to that question.
A DIFFERENT PERSPECTIVE ON BUYING OPTIONS
Imran Lakha at Options Insight, with around 20 years of front-
office options trading experience, has a slightly different
perspective. If you understand how option premium behaves
and the main factors that effect the pricing of these quite simple
and commoditised products, then you can harness the power
of optionality to benefit immensely when you tactically and
selectively buy options.
There is little doubt that since the 2008 financial crisis, global
central banks have effectively declared war on volatility and
will do “whatever it takes” to backstop financial asset prices
at the first signs of trouble. US equities just made new all-time
highs this month and we are still fully expecting a 25 basis
point rate cut from the Federal Reserve at the end-July meeting.
There used to be a time that rate cuts were reserved for crisis
prevention, how that has changed. The powers that be are not
even pretending anymore that asset price inflation is not top of
the policy agenda. Rather than accepting the reality that these
asset inflating policies are doing nothing more than increasing
inequality between the rich and poor, they continue to cling on
to the hope that the wealth effect will generate some kind of
self-sustaining economic growth.
HOW THE PREMIUM OF AN OPTION WILL EVOLVE THROUGH TIME
So in this volatility supressed world, how can buying options
ever make sense? The key to answering this question lies in
knowing how the premium of an option will evolve through time
and different levels of price in the underlying asset. Granted
that if you buy a call option because you are bullish on a stock
and the stock drops like a stone and never looks back, you are
most likely going to lose your premium and there isn’t much you
can do about it. Likewise, if you buy a put option on the Nasdaq
after the market has had a 5% correction and the volatility index
(VIX) has risen from 12 to 25, the odds are you won’t see that
premium again.
HOLDING AN OPTION TO MATURITY
Buying an option and holding it to maturity means that you
have to get the direction of the market right, and it has to stay
there for long enough that your option expires in the money. All
whilst, the time decay keeps eating away at your gains, leaving
you exposed to the risk that your market view might have been
correct but you still lost money. The way to buy options profitably
is to think like a sniper, get in and get out quickly. Options give
you leverage. You can spend a small amount of premium for a
potentially massive return if you catch a big move and cash in on
that move by selling the option out to realise your gains.
A POWERFUL WAY TO TRADE RISK
If done correctly, buying options can be an incredibly efficient
and powerful way to trade risk, generating alpha through
superior risk adjusted returns. Apart from tactically buying
options to gain leverage to a breakout in the price of a stock, a
common use of options is for hedging. Many established money
managers use put options to hedge their portfolios from macro
shocks , enabling them to stay fully invested in the market but
have confidence that their drawdowns will be limited if the
market were to correct sharply lower. The most successful of
these investors also know that once their puts have done their
job in the event of a market crash, then they should monetise
them by either selling them or rolling them in some way either
to lower strikes or longer maturities.
UNDERSTANDING THE AVERAGE DURATION OF VOLATILITY
SPIKES
Like with all forms of trading, you have to evolve with the
market, and options buyers have had to understand that the
average duration of volatility spikes is becoming smaller and
smaller. Therefore, the window of opportunity to monetise
hedges has also become narrower, meaning only the quickest
and most prepared investors will actually be able to profit from
owning these types of positions. The fact that it has become
so challenging to convert a long option position into profit has
led to some investors abandoning using them and also many
long volatility funds closing down due to consistently poor
performance. This in turn has reduced the demand for options
and meant the price for implied volatility has continues to drift
even lower, presenting greater opportunity for those who dare
to step up to the plate and spend premium.
I think most people would agree that it’s good to have options in
life. In the uncertain world we are in today, I suggest that there
may even be a time and a place for them in your investment
portfolio.
We hope this article was helpful. For more information
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