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 notes are yielding something like 1.6%. A yield like that is
certainly not going to fund most peoples retirement!
Given the yield of government bonds, its also no wonder
that assets like high-yield bonds and dividend stocks have taken off in recent
years in terms of cash inflows. If investors cant 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 cash inflows over the last few years.
Even pension funds have started using these overwriting
strategies, as they are commonly called. Its a way to generate yield while
meeting certain risk parameters inherent in those sorts of funds. 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
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 quite 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). Selling
options takes advantage of this overpricing by allowing the seller to become
the insurance company.
Heres 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.
As options become cheaper because of the huge demand from
options sellers, it becomes less and less profitable to do those types of
trades. Whats more, as profitability goes down, it results in risk going up. There
is less cushion in your portfolio (to absorb losses) as margins become
So if selling options has become a crowded strategy, does
that mean that its time to start buying options? To some extent, the answer is
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 definitely 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.
To put it into some perspective, the cost of a 1-month
at-the-money put in SPY is sitting right about at its 52-week average. Considering
how much potential volatility could hit the market with all the headline risk
(political and economic both), it could be a very reasonable time to hedge your
portfolio by purchasing SPY puts.
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