War, the US presidential election, geopolitical tensions, cyber warfare, trade protectionism, the environment and the energy transition, changes to the post-war world order, de-dollarisation, and eye-watering levels of global debt and fiscal deficits all make for an extremely uncertain investing environment. Yet time and again throughout history, the world’s money and investment flows adapt and evolve with the challenges of the day.
Corrections and market downturns inevitably happen, so the key is to prepare for these before they strike rather than after the event. Asset, sector and geographic rotation are the staples for most private investors looking to protect their wealth. But what other alternatives are there? For those willing to invest the time to understand them, options may well be part of the solution for those looking to protect and grow their wealth in these dangerous times.
Why opt for options?
Protecting and growing your wealth are two sides of the same coin. For those with youth on their side, building and holding on to long equities exposure is often recommended as the most effective way to accumulate wealth over time.
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However, what if a 20% market correction (a 20% drop being the common definition of a bear market) happens later in life, leaving you with less time for the market to recoup its losses and make new highs? You could switch from equities to bonds, but this may result in lower capital growth and income compared with holding equities through the economic cycle.
Options provide investors with a readily accessible way to protect (or hedge) their market exposures over multiple different timeframes. With options, it is as easy to go short (by buying a put option) as it is to go long (buying a call option), so these instruments and strategies can be used to position your portfolio and trade in a bear market in just the same way as you could use them in a bull market.
Protect your portfolio with put spreads
The simplest way to hedge a long position that you have in an underlying asset is to buy a put option. If the value of that underlying asset (for example, shares or gold) goes down, you have the right to sell that asset at the put option’s strike price. You may either exercise that option or sell it as it increases in value. However, in times of high volatility, the cost of these options increases significantly, so investors often use put spreads instead of put options. A long put spread involves buying a near-the-money put option and selling (also known as “granting” or “writing”) a further out-of-the-money put option with the same expiry.
The logic behind this is that you can use the premium collected from selling the further out-of-the-money short put option to finance a portion of the nearer-the-money long put option. In this case, the risk is limited to the price you pay for the spread (the value of the near-the-money put less the premium you collect for the further out-of-the-money put) plus commissions and fees. In return for the lower cost of entry you are effectively capping the near-the-money put’s profit potential, so put spreads are best used if you are moderately bearish.
Growing wealth by trading volatility
In uncertain times, market moves can be exaggerated, with volatility increasing significantly. This can be concerning for investors, but it can also generate some interesting opportunities for options traders. The price of an option is determined not just by the strike price, but also by the time to expiry (the longer to expiry, the higher the premium) and volatility (the higher the volatility, the higher the premium). So buying options during periods of low volatility can be a good way to position yourself for anticipated moves in the future.
If you are unsure whether the moves are going to be significantly up (which might be the case if peace is restored in Eastern Europe and/or the Middle East), or significantly down (which might be driven by rapidly rising inflation and interest rates), then you might consider buying a straddle or a strangle.
Straddles and strangles
Straddles and strangles are options strategies that profit from a sharp increase in volatility regardless of whether the stock rises or falls, so long as it moves by a magnitude sufficient to cover the combined cost of both options. Since these are bought-option strategies, the risk is limited to the premium paid for the strategy plus any fees and commissions.
A long straddle is a strategy in which you buy a call option and a put option at-the-money, both with the same strike price and expiration. Together, they produce a position that will profit if the stock makes a big move either up or down. The best time to buy a long straddle is during quiet trading periods – since you will pay less for the two options as their implied volatility will be lower – when you expect that more volatile trading conditions will happen in the future. For example, you might anticipate volatility in Nvidia’s shares when it publishes its quarterly results.
Given the way that the long straddle is set up, only one of the options will have intrinsic value when it expires, but the investor hopes that the value of that option will be enough to earn a profit on the entire position. This allows for theoretically unlimited profit potential on the call option to the upside. The maximum profit from the put option to the downside would be achieved should the asset become worthless.
Strangles are similar to straddles but are more cost-effective because instead of buying relatively expensive at-the-money puts and calls you buy cheaper out-of-the-money options. Although the net initial outlay for a strangle is cheaper, the strategy requires a bigger price move in either direction than a straddle for the trade to become profitable.
Generating income by selling options
Buying options and bought-options strategies limit your risk to the premium paid plus any fees and commissions that you pay to trade them. Conversely, writing them means collecting the premium paid in return for accepting a potentially unlimited risk.
Given this risk profile, why do sophisticated investors choose to grant options? They choose to do so because they feel the premium they can earn from granting options is worth the risk. If the market moves against them they can cover the losses with cash, or they are happy to make or take delivery of the underlying asset at the option’s strike price at expiry.
To illustrate this latter point, a relatively conservative way to grant options is a strategy known as covered calls. This involves granting out-of-the-money call options on a stock that you own.
For example, if you own shares in a UK bank, you might be willing to sell some of those shares if the price goes up by more than a certain percentage in a few months. In this case, you could grant a call option, collect the premium, and be prepared to deliver 1,000 shares in the bank should the option be exercised. If they don’t rise to the strike price by the expiry date, you simply keep the premium you collected.
The risk here is clearly defined and limited because you can easily deliver the underlying stock since you already own it. However, you would forego any further increase in the underlying stock price beyond the strike price. Note if you wrote a call option but did not own the stock, and the option was exercised, you would have to buy the stock in the market to deliver it. This exposes you to uncapped potential losses if the stock soars.
Options: should you use them?
The flexibility of options can make them useful tools for experienced investors, either as an overlay on an underlying portfolio of assets or for tactical trading. Still, as with any investment, your capital is at risk, and derivative products are considerably higher risk and more complex than more conventional investments. They come with a high risk of losing money rapidly due to leverage and are not suitable for everyone. If you’re not sure whether trading in options is right for you, you should contact an independent financial adviser.
James Proudlock is chief executive of OptionsDesk
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