Using Options To Take Advantage Of Volatility

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Includes: QQQX, SPXU, SPY
by: Charles Brokop

When I explain how someone can generate very solid returns with low volatility all while having their money in a money market or other cash vehicle, they usually look at me like a dog that heard a strange noise and give me the tilted head look. The investment discipline does take a while to understand and there are some moving parts involved; however, with the recent high volatility in the market over the past few years, learning this may be a valued strategy. This is an investment strategy that offers strong performance whether the market goes up, down, or stays relatively even, called an ‘Absolute Return Strategy.’ The transactions can also be done in most major brokerage accounts which are another benefit.

The process is like having your own insurance company in which you sell insurance on a group of stocks. One can buy or sell options and most people understand that they can do that on individual companies; however, a number of people don’t understand that they can do it on stock indexes like the SPY, for example, that represents the S&P500 index. Something else they don’t understand is that they can be the buyer or the seller. In our discipline we are the seller much like an insurance company that opens an insurance period by selling an insurance contract to a party. The purchased contract is bought in advance of the insured period and then expires with zero value at the end of the period if no claims are made. That contract is all profit to the insurance company with the insurance buyer losing all their money. Now you may see why so many of the insurance companies advertise on TV all hours of the day on all channels. The insurance business is very profitable and a great income generator when risk is managed properly.

The main drawback of this type of strategy is that it may under-perform the market when the market is rising very fast. This strategy also takes collateral in the form of the money-market funds, stocks or bonds to get started as well. It is not likely to keep pace with an index that rises more than 3% in a given month; however it generally out-performs over time. One of the key reasons for long-term performance is keeping losses small. When you reduce the volatility you reduce losses and that results in fewer losses to make up over time. That is very important as a 20% drawdown requires a 25% gain to get back to break-even.

The benefits certainly outweigh the drawbacks in my opinion. One is that you will certainly not get that bad feeling in your stomach when markets are volatile and you can make money in down markets. You also have a lot of flexibility with this in terms of funds because your funds are not tied up for generally longer than a few weeks. The option positions can be closed during the day and your funds are available on moment’s notice. Following an index as opposed to individual stocks takes out a lot of volatility as well, as indexes are a group of stocks.

The strategy of selling out of the money call and put options on an index allows us to take advantage of volatility instead of having it work against us. We also have time on our side as we want the value of a position to go down over time and preferably expire worthless to the buyer. The CBOE (Chicago Board of Trade) states that approximately 85% of all option contracts expire valueless every month. This is music to the seller’s ears. The positions we take are established every month and we collect premiums from .5% to 2% per month. So you can see over the course of a year the returns add up quite nicely. A risk control process needs to be in place to minimize any losses and keep these to a minimum. You occasionally need to adjust positions quickly based on market direction and should establish the initial positions with a margin of safety.

In over 30 years of investing I’ve never found a discipline that offers these types of returns with low volatility, consistency, flexibility, and small draw downs. The option positions can be sold on the following indexes: SPY, NDX, RUT, and the QQQQ. If you are willing to do this monthly or have someone do it for you, the rewards can be outstanding in all types of markets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I have sold Feb Calls on the NDX in the past 72 hours.