Introduction:

 

Proper portfolio construction and optimal risk management is essential when engaging in options trading to drive portfolio results. Managing a long-term successful options-based portfolio requires a risk tolerance balance between cash, long equity and options. Ideally, an options-based portfolio should be broken out into the below structure while always deploying risk-defined trades via put spreads, call spreads and iron condors in high implied volatility (IV Rank) environments easily identifiable using options screening software. The holistic options-based portfolio can be followed by subscribing to the options trading services. (This is an example breakdown and percentages can be modified): 

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1) ~30% Cash Position - maintaining ample liquidity provides the ability to rapidly adjust when faced with extreme market conditions such as the COVID-19 pandemic and the Q1 2022 market correction due to the confluence of inflation, rising interest rates and geopolitical tensions. Cash also offers the ability to opportunistically build out the long equity portion of the portfolio at substantially reduced valuations and serve as a foundation for long-term appreciation.

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2) ~50% Long Equity - exposure to long equity via broad-based ETFs (i.e. DIA, QQQ, SPY and IWM) allows participation in market movements in areas that are not covered by cash or options. This enables broad market coverage and its recommended to reinvest all dividend payouts to lower cost basis over time. Individual stock positions are encouraged when market opportunities present themselves during heavy sell-offs (i.e., COVID-19 and Q1 2022).  

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3) ~20% Options - options provide outsized gains thus it's not necessary to overleverage one's portfolio to options trading. This is especially important when markets decline and trades become challenged. Balancing options, long equity and cash is essential in appropriate proportions when building an options portfolio.   

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Rules For A Successful Agile Options Strategy:

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Risk management is paramount when engaging in options trading. A slew of protective measures should be deployed if options are used as a means to drive portfolio results. When selling options and running an options-based portfolio the following rules of option trading are essential:

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1. Be an option seller to collect premium income on a routine basis 

   • Continuously bring options income into the portfolio​ while spreading risk over various expiration dates

   • Staggering expiration dates spreads risk and avoids expiration density 

   • Easily identify option trades using the options screening software 

2. Set the probability of success (options delta) in your favor (70%, 85%, etc.) to ensure a statistical edge

   • Delta serves as a proxy for probability of success at expiration of the option contract​

   • Given enough occurrences, the probabilities will reach the predicted outcomes

3. Manage winning trades by closing the trade and realizing profits early in the option lifecycle

   • Realize profits and re-purpose the capital towards additional trades

   • Close out winning trades at >50% premium capture to accelerate the closure of the option prior to expiration 

   • Realizing profits early removes any potential for the stock to challenge the strike price later in the option expiration cycle    ​

4. Sell options in high IV Rank environments to extract rich premiums

   • Predicted volatility is nearly always overestimated and stocks are less volatile than predicted 

   • Selling options with high IV Rank translates into overpriced option premiums that can be collected by option sellers

   • Implied volatility implosion or IV reversion to the mean allows for profits to be taken early when stocks fail to be as volatile as predicted  ​

5. Sell options on tickers that are liquid in the options market

   • Liquidity ensures trades can be filled with tight bid-to-ask spreads for optimal option pricing ​

   • Liquidity is necessary to readily open and close positions 

6. Maximize the number of trades to allow the expected probabilities to play out

   • Occurrences need to be maximized for the predicted outcomes​ to materialize 

   • Placing 10 trades compared to 1,000 trades at a predicted outcome will yield different outcomes as a function of occurrences 

7. Appropriate position sizing / portfolio allocation to manage risk exposure

   • 1-3% of your portfolio should only be used for any given trade ​

   • Risk mitigation needs to be build into every trade relative to portfolio size and risk tolerance 

   • Worst case scenarios always need to be considered thus small allocations to option trades is prudent 

8. Sell options across tickers with ample sector diversity

   • Sell options across uncorrelated sectors to spread risk

   • Too much concentration into any given sector runs the risk of stocks auto-correlating in the same direction and potentially jeopardizing all trades within the sector-specific bucket of trades ​

9. Keeping an adequate amount of cash on hand (~30%)

   • Cash insulates your portfolio against any major market downturns (i.e., Covid-19 and Q1 2022)

   • Cash enables opportunistic buying of long equity to build the foundation of the option portfolio at heavily discounted valuations  ​

10. Risk-defined trades (put spreads, call spreads and iron condors) 

    • Define risk all trades in order to mitigate risk and reduce the amount of capital required for any given trade

    • This limits any losses beyond the protection strike if market conditions deteriorate and move against the trade  ​

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Cash Flexibility is Essential:

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Holding ~30-50% cash as a protective measure is essential when faced with unpredictable outlier situations such as the COVID-19 and Q1 2022 market corrections. A cash position this high is possible because options are a leveraged vehicle thus minimal amounts of capital are required to generate outsized gains with predictable outcomes. Even deploying all the protective measures outlined above will not offer the protection required during a black swan event (i.e., Covid-19 and geopolitical conflicts). During these black swan market meltdowns, all sectors and stocks homogenize and naturally correlate together in a downward spiral. Cash is the safest way to immunize a portfolio from these types of market crashes. This cash position also provides optionality to go long stock in high quality names when faced with extreme sell-offs. The long equity portion of the portfolio can be built out during these periods and snap up companies at heavily reduced valuations. The long equity portion of the portfolio serves as a foundation for appreciation when market conditions improve over time.    

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