Controlling portfolio volatility is essential as the broader markets continue to break record high after record high along with violent pullbacks. The past three-month stretch of September-November was a prime example as the markets pushed to new all-time highs early in September then suffered a significant sell-off in the same month where the Dow Jones was down as much as 6%. October saw a bounce back into positive territory with new all-time highs set. Then November saw a dichotomy between the Nasdaq continuing to break out to new highs while the Dow Jones experienced significant weakness.
Amid this mixed market and broader index bifurcation, entire sectors were decimated. The payment space was heavily impacted with PayPal (PYPL) and Visa (V) taking huge market capitalization reductions by 37% and 21%, respectively. Quarterly reports have been detrimental for companies that report slight misses or in-line numbers with poor guidance. Disney (DIS) and International Business Machines Corporation (IBM) saw their stocks plummet 24% and 20%, respectively from their 52-week highs. An options-based portfolio can offer mitigation against these pockets of extreme volatility while generating consistent and smoother returns.
Options-Based Risk Mitigation
Risk mitigation can be achieved via a blended options-based approach where the portfolio is broken out into three components. Cash, long equity exposure, and an options component are the three pillars of an options-based portfolio strategy. Options alone cannot be the sole driver of portfolio appreciation. However, options can play a critical component in the overall portfolio construction to control volatility and mitigate risk.
Generating consistent results while defining risk, leveraging a minimal amount of capital, and maximizing return on investment is the core of an options-based portfolio strategy. Options can enable smooth and consistent portfolio appreciation without guessing which way the market will move. Options allow one to generate consistent monthly income in a high probability manner in various market scenarios. An options-based portfolio provides durability and resiliency in the face of market volatility with substantially less risk.
The Options Component
Options are great for defining risk, leveraging a minimal amount of capital, and maximizing return on investment. However, options need to be deployed in a responsible manner, via always risk-defining trades and keeping portfolio allocation reasonable. A disciplined approach to an agile options-based portfolio is essential to navigate pockets of volatility and circumvent market declines. A slew of protective measures should be deployed if options are used to drive portfolio results. When selling options and managing an options-based portfolio, the following guidelines are essential:
1. Trade across a wide array of uncorrelated tickers
2. Maximize sector diversity
3. Spread option contracts over various expiration dates
4. Sell options in high implied volatility environments
5. Manage winning trades
6. Use defined-risk trades
7. Maintains a ~50% cash level
8. Maximize the number of trades, so the probabilities play out to the expected outcomes
9. Place probability of success in your favor (delta)
10. Appropriate position sizing/trade allocation
Figure 1 – Options-based portfolio rules for the options trading component of the portfolio when combined with long equity and cash components compared available via a Trade notification service - Trade Notification Service
Controlling portfolio volatility is essential as markets and whole sectors are whipsawed. The recent September-November stretch was a prime example and reinforces why appropriate risk management is essential. An options-based approach provides a margin of safety while circumventing the impacts of drastic market moves as well as containing portfolio volatility. An option, cash, and long equity hybrid portfolio provide durability and resiliency during pockets of market turbulence. A disciplined approach to an agile options-based portfolio is essential via an array of protective measures that are required to be deployed if options are used to drive portfolio results. When selling options, the 10 rules must be exercised for each options trade that is executed.
Disclosure: Stock Options Dad LLC is a Registered Investment Advising (RIA) firm specializing in options-based services and education. There are no business relationships with any companies mentioned in this article. This article reflects the opinions of the RIA. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. The author encourages all investors to conduct their own research and due diligence prior to investing or taking any actions in options trading. Please feel free to comment and provide feedback; the author values all responses. The author is the founder and Managing Member of Stock Options Dad LLC – A Registered Investment Advising (RIA) firm www.stockoptionsdad.com defining risk, leveraging a minimal amount of capital and maximizing return on investment. For more engaging, short-duration options-based content, visit Stock Options Dad LLC’s YouTube channel. Please direct all inquires to [email protected]. The author holds shares of AAPL, AMZN, DIA, GOOGL, JPM, MSFT, QQQ, SPY, and USO.