At Christmas Corp, we continuously seek new ways to optimize clients' returns. There are some instruments that we believe are useful for enhancing the return or reducing the risk of our portfolio. This time we'll share our experience with stock options.

The wonderful thing about options is their flexibility. In theory, we can make a profit from any price direction: whether the stock price goes up, down, or doesn't change at all. Further, the trading return can be very different from the underlying return; in other words, options provide asymmetric returns. For example, if we believe a stock will slightly increase, we can set a position to yield twice or even tenfold of the stock return.

However, its flexibility comes with a trade-off.

Options trading is much more complex than stock trading. For starters, we need to understand options behavior or the greeks. Many skip learning this and pay a hefty price. Second, we need to have a decent infrastructure for options trading. For example, having access to good historical implied volatility data. Finally, there is a countless combination of options for every price bet. Forecasting a stock price direction is tiring enough, and we need to decide the magnitude, timing, and options strategy that we will use.

The trade must be perfect

We need to be right on three things: direction, magnitude, and timing in options trading.

For example, GRAB. This stock's short position is very tempting, even after its big drop post-IPO. The company is burning money, and the competition in super-apps is nowhere near ending. However, everyone in South East Asia is using super-apps, and there are always new investors keen to invest in it. So, a long put must be a good trade, isn't it?

It depends on your forecast of directions, magnitude, and time. All must be right for a profit. A Mar 25, 5.50 put options costs $58 per contract. The maximum profit is $492 if GRAB falls to $0. To make a profit, GRAB must fall faster than the time decay of its premium. By Mar 25, 2022, GRAB must fall below $4.92 per share to profit.

Below is the table of profit/loss in percentage of Mar 25, 5.50 put options. 


Unless intended for pure speculative trading, we won't enter this trade. Fundamental assessment is a thing, but we need every other thing right: direction, magnitude, and timing. If GRAB falls to $3 by Mar 26 instead of Mar 25, we will lose 100%. If GRAB rises by 1.5% soon after entering this trade, we will lose 6.9%. Everything must be perfect.
 

Execution risk

After deciding to enter a long put on GRAB, we'll face another problem: the bid-ask spread is wide. A wide bid-ask spread means our trade will take longer to find a seller (we are a buyer of a put), or we need to raise our bid (and make our trade less favorable). At this writing, the bid-ask spread of Mar 25 5.50 put options is 26% wide. The bid was $0.50, and the ask was $0.65. This is in contrast to the underlying. The bid-ask for GRAB stock was $5.53-5.55, a very tight spread.

Indeed, not all options have a wide bid-ask spread. We will not see a very tight spread in AAPL or other S&P 500's stock options. It's a matter of liquidity. The more liquid a stock, its options are likely to be very fluid too. This may not be a problem for retail traders with a small trading size. But this is significantly risky for a larger trader with millions in total assets.

Evolving trades

What makes options interesting is their flexibility to adjust existing trades. For example, our favorite strategy: diagonal spread.

In the case of a diagonal call spread, it involves buying a long-dated in-the-money call and selling a near-term call. We prefer buying deep-in-the-money call for its stock-like behavior and selling at-the-money call for its neutrality. Theoretically, our profit will come from the difference in time decay. The near-term call's time decay is faster than the long-dated's. The trade also benefits from rising volatility and doesn't get hurt from falling volatility. 

 
This diagonal spread doesn't need constant monitoring like our GRAB options. The time decay is beneficial, and volatility risk is neutralized. Further, it provides a small margin of safety if the stock price falls slightly. However, the trade will severely lose if stock prices fall deeper.

Fortunately, we can always adjust any options trade. If our IBM share price falls below $120 when the short call expires, we can sell another call with further expiry (rollover). Our overall value will be at an unrealized loss, but rolling over the short call two or three times can double or triple the realized return later when the share price rebounds. Our typical diagonal trade returned 10% per trade, but some which fortunate enough to be rolled over produced>30% per trade.

Back to fundamentals

Our diagonal spread relies much on our view of the stock price direction. The most important thing is finding stocks that are not likely to fall deeply. About the timing, those with superb timing skills can choose the in-the-money option with near expiry. But those with terrible timing skills should choose further expiry.

Having a solid view of the stock is necessary for options trading. It improves the chance of profit of a trade. And if the trade goes sour, we'll be ready for the best adjustments: evolving the trade or simply cutting the losses.

Lastly, options trading is by no means a get-rich-quick scheme. If we can gain 30% per trade in three months, we can see also a loss of 30% per trade in three months. Diversification and asset allocation are a must.

Implementation of our portfolio

Sadly, since there are no fractional options, we cannot employ this wonderful instrument in our Signature strategy. Without fractional features, the execution risk of allocating weight to each client would be too high.

Stay evolved.