Seven strategies for navigating volatility
Investors hate uncertainty. But how should they deal with it? Of course, this depends entirely on your vision. If you think market gyrations are temporary and heavily exaggerated, then you do not need to move. But if you think markets could fall further in the future, it is important to take action. Here's Seven strategies for navigating volatility.
1. Cash is king
Take a broad look at your total portfolio and forget about the original purchase prices. Instead, look at your total net worth, because your overall capital value should be your primary consideration. With this approach, you can rise above the level of your individual current holdings, and shape your entire portfolio in ways that are most prudent.
Consider your portfolio through this lens: if you had the value of your current portfolio entirely in cash and wished to invest, would your portfolio look exactly like it does today? If you are completely satisfied, no action is needed. If you are not, make the changes that will heighten your comfort level. And the easiest way to do this is to turn your equity holdings into cash. For example, would you prefer to lower the risk of the portfolio by 50%? Then you should halve your position.
2. Exchange shares for long-term calls
When you buy a call option, you pay a premium—but this is also your maximum loss. On the other hand, if you buy a share, you could lose all the money you invested in that share. So you may choose during times of market turmoil to buy a long-term call option on a share that is “in the money”.
For example, the call option on a $15 share, with a time to maturity of two years and a strike price of $12 (meaning you have the right to buy the share for $12 within the next two years) will cost (depending on volatility) $4. This $4 premium is your maximum loss.
If the stock price drops from $15 to $7.50 and you own the share, you will lose $7.50. While the call option would also decrease in value, your loss would be much lower than $7.50. And if the market moves the other way and the stock price rises, you will benefit via the long call.
3. Sell a portion of your shares and write puts
Imagine that you own 1,000 shares in a company. While you have confidence in the company’s prospects, you also notice that its stock falls when the broader market falls, and you see some dark clouds for the market in general.
What you can now consider is selling half of the shares, and at the same time writing (i.e., selling) five put options below the current stock price. If the stock goes up, you will earn from the 500 shares you still own. You can also label the received option premium as a profit because they will expire worthless.
On the other hand, if the stock drops further, you will be obliged to buy the shares at the exercise price of the put option you sold. However, this means that you will repurchase your 500 sold shares at a lower level than the original sell price—skipping a part of the decline.
4. Write a call on stocks in your portfolio
If you write a call option, you enter an obligation to deliver. For a lot of investors this feels annoying because it hinders the upside potential. The question is whether this is really the case.
Assume a share is trading at $10 and the call option with a strike price of $11 is quoted at $1. If you write this call (one call per 100 shares you own), you have built up a buffer of $1 for a decrease in that stock. That is not enough if the share loses 50%, but it is better than nothing.
Meanwhile, if the stock goes up, you can do two things. The first is to do nothing and then deliver the stock at $11 (effectively $12 because of the $1 option premium received). The second is to roll the written call to a higher strike price, if you don’t wish to deliver the underlying stock. The time to do this is when the written call is “at the money”, as you will be able to roll the written call with a credit.
5. Protect your shares by buying put options
By buying a put option, you get the right to sell the underlying for the strike price until expiration of the option. However, many investors consider puts too expensive. An “at the money” put option could easily cost 8-10% of the price of the underlying, or even higher in a high-volatility environment. So while buying puts can protect your shares, it’s an expensive solution.
A slightly cheaper possibility is to buy a put spread instead of an individual put. In this case, the investment is smaller but the protection is also limited.
6. Protect your stock investment with a collar position
In this strategy, you write an “out of the money” call option and buy a put option from the proceeds. This means that you enter into an obligation to deliver the underlying at a higher level (i.e., the written call), but you also gain the right to sell the underlying at the strike price of the put option (i.e., the bought put). You limit your upside potential but also your downside risk.
7. Write both call and put options
Assume again that you own 1,000 shares in a company. In this scenario, you would sell 500 shares (half of your position) and then a) write five puts with a lower strike price and b) sell five calls at a higher strike price. The option premium you receive for both calls and puts is a buffer for a moderate decline in the share price. And again—if you are not bullish on the stock in the long term and afraid the share price may plummet, sell all your shares.
If the stock falls, you will be required to buy 500 shares at a significantly lower level than at which you sold them. And if the stock goes up, you either roll the written call (see above) or deliver the shares at the strike price of the call option you sold.
Stick to your size
If you follow the strategy of selling naked puts in order to receive the premium but without the desire to actually buy the underlying shares, make sure you keep your size in check. Too often, investors only look at the margin obligation that writing options entails. They forget to look at the actual risk involved. If the share is $10, the margin obligation of a naked short put might be $150. This may lead to investors selling too many puts because they can easily comply with the required margin. In a falling stock market, this strategy can cause a lot of misery. So stick to your size, especially if you write puts. Do not look at the margin, look at the underlying exposure.
In summary, options offer sufficient opportunities to consolidate a profit. But before you apply any of the above strategies, make sure you understand them completely.
