Option-Based Strategies: Opt In or Opt Out?

Harvesting Fear and Greed

May 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Option-based strategies generated better risk-adjusted returns than the S&P 500 over the last 30 years
  • Investors should be wary of buying options and focus on harvesting the volatility risk premium by writing options
  • Option-based strategies are an interesting alternative to long-short equity hedge funds for reducing risk

BUYING VERSUS SELLING OPTIONS

The investment banking divisions of Goldman Sachs, Morgan Stanley, and similar firms pride themselves on servicing sophisticated, blue-chip institutional clients. They mostly avoid the retail market because there is less to be gained – except for certain niches that are too profitable to ignore. Selling derivatives to German retail investors is one such niche.

Although German investors tend toward the conservative, with an unhealthy preference for low-interest–paying saving accounts, many have a dark side that manifests itself in the trading of such highly complex derivatives as digital or Asian options. Retail investors are not well-equipped to use or price options. This means they mostly lose money, but it makes an attractive business for the investment banks issuing the options.

But there is a big difference between buying options – often for speculation – and selling them, which exploits the fear, greed, and ignorance of investors. Some US mutual funds pursue strategies that include writing options, whether to generate additional income or to offer protection against market crashes (read Hedging Market Crashes with Factor Exposure).

Given low interest rates and concerns about a market downturn, option-based approaches have become popular in the United States in recent years. Currently, there are more than 70 such strategies – an all-time high. So do option-based approaches offer any value to investors?

THE LONG-TERM EVIDENCE

The Chicago Board Options Exchange (CBOE) publishes indices for several option-based strategies with data going back 30 years. Two of these indices are among the most well-known:

  • CBOE S&P 500 BuyWrite Index (BXM)