Despite the COVID-19 backdrop, some individual stocks and broader indices have exploded to new all-time highs and retraced previous all-time highs, respectively. Since the depths of the COVID-19 induced sell-off in late March, the markets have experienced an uninterrupted resurgence. It’s easy to become complacent when markets are roaring higher. However, one must remain disciplined when managing risk, especially as it relates to options trading. Mitigating risk and maximizing returns is paramount as the markets rotate out of the depths COVID-19 sell-off. Options trading offers the optimal balance between risk and reward while providing a margin of downside protection and a statistical edge. Proper portfolio construction and optimal risk management is essential when engaging in options trading as a means to drive portfolio performance. The Q4 2018 and the COVID-19 pandemic are prime examples of why maintaining liquidity, risk-defining trades, staggering options expiration dates, trading across a wide array of uncorrelated tickers, maximizing the number of trades, appropriate position allocation and selling options to collect premium income are keys to an effective long-term options strategy.
An Effective Long-Term Options Strategy
A slew of protective measures should be deployed if options are used as a means to drive portfolio results. One of the main pillars when building an options-based portfolio is maintaining a significant portion of cash-on-hand. This cash position provides the ability to rapidly adapt when faced with extreme market conditions such as COVID-19 and Q4 2018 sell-offs. When selling options and running an options-based portfolio, the following guidelines are essential (Figures 1 and 2):
- 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 environment
- 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. Continue to trade through all market environments
- 10. Appropriate position sizing/trade allocation
Figure 1 – Defining the 10 rules that one must follow to appropriately manage risk and maximize returns when deploying options as a means to drive portfolio results
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