Blog 3: What investment approach will I take? Option Investing
In my previous posts, I set the scene by discussing the main ways investors can be active. I wrote at a high level about different kinds of active decisions in portfolio management—asset allocation, market timing, and security selection—but I did not discuss exactly what I want to blog about or the specific active strategy I intend to pursue. So, without further ado, I will discuss and engage in option investing.
Option investing involves asset allocation, market timing, and security selection. Specifically, the allocation decision is about the amount of capital we dedicate to options trading. The market timing component involves judging when to sell (or buy) the options. The security selection component involves choosing the underlying securities on which to trade those options.
For now, my approach to these considerations is as follows: we should allocate 10% of the portfolio to an options strategy, write options in a way that avoids hard-to-anticipate outcomes (such as earnings reports and investor events), and focus on US companies because those markets are sufficiently liquid. Of course, I may change my mind over time if the facts change.
Next, I want to discuss the elements that make options investing interesting and worth pursuing.
Why options?
I will not discuss the intricate details of how options work; plenty of resources on that can be found elsewhere online. The more important question is: why do I want to invest in options?
There are two things I find attractive about trading options, particularly writing them. As you may know, a call (put) option gives the owner the right to buy (or sell) a stock at a certain price (the strike price) by a certain date in the future.
Because the buyer pays a premium, the seller receives that premium. This is the first attractive element: writing options generates upfront income, similar to how an insurance company works. Most of the time, nothing “bad” happens and insurers don’t need to pay out. Occasionally, disaster strikes and they must pay. The objective is to earn enough premium to more than offset the payouts when market conditions deteriorate. Therefore, option writing often results in small, steady wins, but writers will occasionally be assigned and realize meaningful losses. I am well aware of this; this blog is not about unknowingly picking up pennies in front of a steamroller.
A second interesting element is that options have an expiry date. This means that if the underlying instrument does not move enough by a certain point in time, the option expires worthless. In that case, the full premium is kept by the writer. In other words, as an option writer, you have time on your side. As long as nothing happens and time progresses, you make money. In technical terms, options have “negative theta”—they lose value as time progresses. Conversely, option sellers have “positive theta” exposure.
While time is on our side and options often expire worthless, we must remain wary. High option premiums (high implied volatility) often reflect that the person on the other side of the trade—typically a sophisticated market maker—expects firm-specific news that will move the stock. There is no such thing as a free lunch, and we may actually want to avoid options with excessively high implied volatility.
The elephant in the room
Before we continue, let’s address the elephant in the room. With the options market dominated by large institutional players and market makers, a fair question is whether any superior returns (alpha) can actually be made. The answer is that trading options is not “easy money.” However, if we aren’t looking for opportunities, we will certainly never find them.
More than anything else, this is what this blog and my approach will be about. I will screen the US stock option universe to identify attractive opportunities and then trade them. I will also evaluate the quality of my calls after the fact in the hopes of learning from them.
Conclusion
In a nutshell, this blog will focus on trading individual stock options on US equities. Specifically, the focus will be on writing options using 10% of a portfolio while avoiding volatile company events. Most of the time, these options should expire worthless because, as writers, we have time on our side.