You Are Using Options Too Much

Summary

• Options are not meant for widespread use as they are being used today.
• Low return and high risk make the asset class dangerous.
• In most cases, simply buying or selling equity is better than playing options.
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courtneyk

In observing pointillism paintings up close, all one will see is a smattering of dots. Step a few meters back and the brilliant work of art comes into focus.

Finding the right answer can be a simple matter of perspective. I think people can benefit from the same broader perspective when deciding where to allocate capital.

Which asset class is best?

There are many ways to allocate one's spare capital. Options are increasingly becoming a popular way to invest, but before I get to options, let us establish a framework using 5 of the large traditional buckets.

• Savings/checking account
• Government bonds
• Corporate bonds
• Preferred equity
• Common equity

Each of these comes with very clear benefits that could make it the ideal choice for an individual's needs. Common and preferred equity come with the highest expected return but also the highest risk. On the other side, a checking account provides the lowest return but the highest safety and liquidity. A savings account is equally safe as a checking as both are FDIC insured, but sacrifices a slight bit of liquidity in exchange for a higher interest rate.

Treasury bonds are the next rung of the ladder with marginally less safety due to price volatility and less liquidity, but they pay a bit more. You get the point. There is a neat and clean tradeoff between return and some composite of safety/liquidity.

Asset Type	Rank in Expected Return (rough annual return)	Rank in Safety/Liquidity
Common equity	#1 ~8-10% annual return	#5
Preferred equity	#2 ~7% annual return	#4
Corporate bonds	#3 ~5% annual return	#3
Government bonds	#4 ~4% annual return	#2
Checking/savings	#5 ~0%-3% annual return	#1

Click to enlarge

Mispricing of course allows one to violate these rules by providing the opportunity to get higher return AND lower risk, but for the purposes of this discussion, we are looking at the asset types from a broad level where these rules generally hold true.

Options are a bit trickier to fit into this mix. There are of course a wide variety of options one can buy, but for the sake of simplicity, let us consider the basic kinds.

• Buy a call option
• Write/sell a call option
• Buy a put option
• Write/sell a put option

Unlike the other asset classes, it is quite difficult to assess the risk and return levels of an option because it is contingent upon strike price, premium paid, and timing window. To address this, options traders will use graphical representations of the payoff zones.

poems.in

Diagrams such as the one above make it fairly straightforward to understand exactly what bet one is making when buying or selling an option. They can know the price they need the security to reach to make a profit and the time by which they need the security to hit that price.

But what is the expected return and what is the risk?

Looking at an individual options play is the equivalent of standing too close to the pointillism painting. The expected return comes down to a guess or perhaps an educated guess about the future price and due to the expiry window fundamentals do not necessarily drive the price to the expected price in the way that they do over the long run for an equity.

As such, when looking at an individual option, the expected return is unknown. However, much like the painting, if you look from a broader perspective the expected return has a very clear answer.

The expected return of options is zero minus trading commissions

Quite simply, options are a zero-sum game. For any given option there is a counterparty and their payoff diagram is a precise mirror image flipped about the X axis of your payoff diagram.

Therefore, the expected return is zero and one can only make a profit on options by consistently outsmarting the people on the other end of the trade.

In equity trading, one's return is their alpha + the base return of the market, which is usually 8%-10%. In options trading, one's return is just their alpha.

That is a tough way to invest.

One is essentially tying up their capital for potentially no return. It may not seem like capital is being tied up depending on the type of option used, but it does require capital to sit dormant.

When buying a call or put option, the premium paid is an upfront capital cost. When selling a call or put option, one has to hold capital in a form such that they can cover if the option is exercised.

Options fundamentally violate the risk/reward tradeoff

Despite having zero expected return, options are generally fairly high on the risk spectrum.

Consider a basic sine wave type of graph that is typical of many financial instruments. The slope is the expected return while the amplitude of the wave is functionally the volatility or risk. Options payoffs tend to come in big chunks. Most long options will lose money from the upfront premium but those that payoff can payoff big time, sometimes resulting in 5X-15X returns (as compared to the premium paid). That seems like a high amplitude of volatility to me, which makes options generally a terrible deal on the reward/risk spectrum. I would place them at the highest risk and lowest expected return as compared to the main asset classes previously discussed.

That said, there are some viable uses of options

When to use options

Options can be used as risk mitigation tools. It is quite common for companies to use options to hedge against currency or interest rate risk. It is essentially a way to partially nullify exposure to a factor that one otherwise incurs as a normal result of their investment or business.

In such instances, options can viably be used with full knowledge that they do not provide a positive expected return as when used correctly they can mitigate risk.

Even in noting these correct uses, I feel inclined to point out that they do not always provide the protection they are supposed to provide.

Failures in options-based risk mitigation

The financial industry talks about options as a form of "protection" or hedging, which oversells the actual level of risk mitigation.

The protections provided are so specific that it is more akin to home-owner's insurance that covers burglaries but does not cover floods or fire.

Time and time again, I have watched as companies and individuals lose on things that were superficially covered by options hedges. For example, almost all of the mortgage REITs were hedged against rising interest rates yet almost without exception their book values plummeted as the Fed raised rates.

Why?

Well, it is the specificity of the options. Their hedges only covered properly for a parallel shift to the yield curve, but it wasn't parallel, the curve twisted, so the options-based hedges didn't really work.

Other companies try to cover their floating rate debt with swaptions designed to make the debt functionally fixed rate. These too often fail as perhaps interest rates don't go up during the options window but rise after the swaps expire. Or perhaps as the swaps are about to expire, the cost to renew the swaps becomes unbearably high because the market is anticipating interest rates rising.

Thus, even when used as a hedge, I think it is imperative to recognize that options are still a targeted bet that a specific thing will happen within a specific timing window.

• A company hedging interest rates is essentially making a bet that interest rates will rise in a pre-specified parallel or twisting way within X number of months.
• An individual writing covered calls against one of their long positions is making a bet that the stock will have low volatility for X number of months as they lose if the stock crashes and miss out on gains if the stock soars.
• A trader buying "protection" by buying puts to cover their longs is making a bet that the market is going to drop within X number of months.

Why the financial services industry loves options

It is difficult to watch an hour of financial television without seeing an advertisement for options trading platforms from the standard brokerages like Schwab or TD Ameritrade.

There is a very simple reason that they encourage options trading. Each trade incurs a commission, either directly via a fee commission of indirectly through PFOF (payment for order flow). Options by their nature are limited duration, which forces the trader to have to re-trade the same assets continually to stay invested. It is a recurring source of revenue for the brokers.

The bottom line

Consider using options substantially less or not at all. While specific options trades might look good, they are zero expected return before commissions, so every bit of return one gets from options has to come from outsmarting the world.

I'm not smart enough to play that game, and those who are, would probably still be better off buying equities or bonds where they can get their alpha plus the base return.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.