Options: Removing Equities from My Portfolios and Never Looking Back

Despite successful colleagues dabbling in it over the years, it wasn’t until 2019 that I really discovered the amazing world of trading options. I had spent a chunk of my summer that year experiencing the bittersweet sting of the consequences of stock picking.

Ironically, in July 2019, I bought NVDA for $40 per share, AMZN for $100 per share, ANET for $70 per share, and would have averaged a 38.06% CAGR and nearly quintupled my capital had I held the shares, but I couldn’t resist trying to play the macro game; a game in which I had no understanding or experience (and got a hands-on lesson in just how inexperienced I was). Perhaps I flew a little too close to the sun.

Options had instant appeal to me following my memorable (though fortunately not devastating) 2019 equities losses. This “instant appeal” occurred the second that I realized that I could both provide downside protection and generate alpha (outperform the market) in my portfolio at the same time.

One function of options is that they can act as an insurance policy for options buyers (even as an insurance policy in a way for sellers as they lower your basis when you account for premium), and with the right strategy, as a consistent income stream with exceptional risk-adjusted returns as an options seller.

I immediately went to YouTube and discovered the world of selling cash-secured puts, covered calls, and attempting to learn the Greeks, which can easily become overwhelming to someone just jumping in. Like anything else, there was almost too much information and I didn’t know where to begin. I didn’t want to learn the wrong thing and have to constantly battle with that once I found something that started to work for me.

Through a mutual friend, I eventually stumbled across a very knowledgeable and successful options trader named David. David had been trading options for years and was even thinking about starting a hedge fund at this time.

I offered to pay David to teach me everything that he knew, but he refused and explained that he would gladly send over some resources for me to get started free of charge. What a guy!

While I was very excited to begin learning this from someone who had been in the trenches every day doing it for years, my excitement was quickly replaced by overwhelm.

Short Vol, Alpha, Beta, Theta, IV, POP, and PCR…

It was gibberish to me at that point in my journey, as lingo can so often be for anyone new to something, but I was committed to learning it. I knew enough of the basics to realize what a game-changer this would be for my investing.

David explained several of his strategies to me that taught me a lot about what it takes to be a good trader with a real edge and not one of those traders constantly chasing the latest and greatest indicator strategies spammed all across YouTube.

Use market behavior and patterns to your advantage and play as the house (you can never truly be the house as a retail trader, but as close as possible) and not the gambler. In other words, focus on being a seller instead of a buyer to make money consistently. Furthermore, stick with a non-directional strategy that will result in consistent returns without having to predict market direction.

The market doesn’t change and doesn’t learn. The market isn’t efficient. “Present fear of future uncertainty is fundamentally overpriced… hence the reason the insurance market exists…” This brilliant quote from a Tastylive episode has stuck with me.

Tired of having to be right to make money? As I mentioned earlier, one of David’s key pieces of advice was to explore options strategies that don’t require you to be right about market direction to make money. I wasn’t even aware that such strategies were possible, but they are plentiful in the world of options.

Don’t want overnight risk? No problem, options can have you covered here (no pun intended). Another thing I learned was that most major market moves occur after hours or overnight, for a multitude of reasons. Despite the lower liquidity, many managers also strategically use this time to announce news that moves the market, giving the market time to digest it before the New York open. I realized that, in many cases, by only having intraday exposure, I was only exposed after the market had already had its major move.

Stop losses and downside protection for sudden volatility spikes or market moves? Check. Yes, this is still possible with equities (to a point), but there are certain built-in protections with options that equities do not have. I want you to imagine the concept of buying a house with no insurance on it. That’s what most equities investors who do not utilize options do daily. However, it is important to remember that it’s not risk-free and that it’s important to manage your risk and size. There are more tools to do this with options than just about any other investing strategy.

Tax advantages? “I’ll take ‘What Is Section 1256 for 500, Alex.'” Sure, there’s always some tax genius out there who would argue that I’m missing the power of unrealized gains and margin loans, but not everyone has a cool $20-50MM liquid to comfortably implement that strategy over the long term. Don’t even get me started on the 4% rule nonsense. (Talk to your tax advisor, I can’t give you tax advice.)

Beating the indexes? We’re seeing double and triple the returns that we saw in our SPY portfolio, with just a fraction of the volatility. Not only have the returns been superior, but I see them being much more dependable than the equities markets in the future (i.e. bull market phenomenon, debt crisis, etc). Even though most asset appreciation is inflationary and I don’t see that changing any time soon, I like knowing that I have more control over my returns from selling premium.

By the time I even spent a few hours learning about trading options, I found that I had countless questions, but it didn’t take long for one question to rise above all the rest…

Where have options been all of my life?

by Phil Steptoe

April 23, 2024