Value is on the Side of Options Buyers Instead of Writers

10/07/2019 10:04 am EST

Focus: OPTIONS

Jay Soloff

Editor, Options Profit Engine

With so many traders looking for yield by writing options, it is time to make a value play by buying options, writes Jay Soloff.

In a world of ultra-low interest rates, it seems every investor is searching for yield. Of course, that should come as no surprise when 10-year Treasury notes are yielding something around 1.6%. A yield like that is certainly not going to fund most people’s retirement.

Given the yield of government bonds, it’s also no wonder that assets like high-yield corporate bonds and dividend stocks have taken off in recent years in terms of cash inflows. If investors can’t get the yield they seek in Treasuries, they will turn to other investment vehicles.

And that's where options come in. Investors have always been able to use options strategies to generate income. However, recently, income-generating strategies have exploded in popularity. Well-known strategies such as covered calls and cash-secured puts have received billions in allocations over the last few years.

Even pension funds have started using these overwriting strategies, as they are commonly called. It’s a way to generate yield while meeting certain risk parameters inherent in those sorts of investments. In other words, pension funds care about risk-adjusted returns far more than ordinary returns. Using options for overwriting can certainly help “smooth out returns over time.

Getting back to overwriting, the one thing all overwriting strategies have in common is that they will be a net seller of options, used to generate income. That means you need to sell more options than you buy if you want to earn a credit on the trade.

Whatever you may have heard about selling options, it can be done safely using proper risk management techniques. For example, a covered call strategy is generally safer to use than a simple buy and hold strategy – otherwise, you wouldn't see pension funds pouring money into it.

In a nutshell, options tend to be overpriced relative to their fair value because investors use them as protection (insurance). Better put—no pun intended—buying options allows you to limit your risk to the premium paid, selling option collects an extra premium for providing that assurance. Selling options takes advantage of this overpricing by allowing the seller to become the insurance company.

Here’s the thing…

The problem with the skyrocketing popularity of selling options for income is that is has become a very crowded trade. That is, so many people/funds are doing it that is has depressed the price of options in many of the most popular products. In other words, sellers have arbitraged out a lot of the extra premium for provided buyers with the assurance of defined risk.

As options become cheaper because of the huge demand from options sellers, it becomes less and less profitable to do those types of trades. What’s more, as profitability goes down, it results in risk going up. There is less cushion in your portfolio (to absorb losses) as margins become razor-thin.

So if selling options has become a crowded strategy, does that mean that it’s time to start buying options? To some extent, the answer is yes.

Keep in mind; buying options can be a challenging way to make money because of time decay. Options you own will slowly (or quickly in some cases) lose money as you get closer to expiration. That means you have to be extra careful before going out and loading up on long options.

That being said, there are quite a bit more opportunities to buy options now than there has been in years. For instance, buying cheap insurance on SPDR S&P 500 ETF (SPY) may make a lot of sense right now.

spy

For perspective, the cost of a one-month at-the-money SPY put is near its 52-week average. Considering how much potential volatility could hit the market with all the headline risk (political and economic), it could be a very reasonable time to hedge your portfolio by purchasing SPY puts.

The industry often calls selling options picking up nickels in front of a steamroller. That’s ok if you keep a safe distance. As more traders sell options, the closer they need to get to the steamroller to collect any premium. At some point it is better to be the steamroller.

Jay Soloff is the Options Portfolio Manager at Investors Alley. He is the editor for Options Profit Engine, an investment advisory bringing you professional options trading strategies, with all the bells and whistles of Wall Street, but simplified so all you have to do is enter the trades with your broker. 

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