Tips for an Option-Based Long-Term Portfolio

Was since 2020 when, in a revolutionary decision, the main US brokers (Ameritrade, Fidelity, Charles Schwab, eTrade) decide to offer zero-commission in stocks, ETFs, and options trading, that the stock market's control changed forever: now the retail traders, decide face to face with institutional and hedge funds, the trend it will take.  Seems unbelievable, but is a fact. One consequence is the unstoppable meme stock phenomenon we have until now, with its exaggerated volume trading and yields, in which buy the dip is almost a religion for novice traders, and use OTM cheap calls, its bible. 

For other retailers like me, that maintain a month-rebalanced long-term portfolio (apart from the usual swing/day trades), it was a great opportunity to start trading options more aggressively, buying ITM options and credit spreads instead of merely stocks, thus creating an options-based portfolio as now commissions are no longer cutting dramatically the profits. Below, I share here some tips for taking advantage of the power of options in a long-term portfolio.

Options as a substitute for Stocks: Delta > 0.80

Substituting stocks with options has two unique advantages: only options bring leverage and protection.

- Options provide tremendous financial leverage to users when they are used in a conservative way: you can control the same amount of shares with less money, and mainly, the % returns are much higher when you trade with options. This carries another advantage: with more money available you can diversify better your portfolio.

- And provide protection: with the appropriate strategy, in case of a devastating fall of the stock, your maximum loss is always limited to the amount of the call purchase.  The use of stop-loss in stock trading works reasonably well but does not always prevent losses due to frequent morning gaps. Stop-loss orders offer protection that is path-dependent (depends on the "path" the stock takes), while options offer time-dependent protection (and never trigger you out of the position just because of the path the stock, as stop-loss did).

Options are two-dimensional assets: you must guess correctly the direction and the speed of the underlying stock. When a stock-trader becomes an option-trader they often buy at-the-money call options (since they are cheaper) as a substitute for the stock. Doing so subjects them to a two-dimensional asset when they are used to trading stocks, a one-dimensional asset. When you starting out, buy short-term options in-the-money (ITM), calls with relatively high deltas in the 0.80-0.85 range and you will have an asset that behaves similarly to the stock you are trading. They are more expensive than ATM or OTM options, but less risky.

The reason is that a call option with a delta of 1.0 is no longer considered an option, it's a perfect stock substitute. There is no time-premium there, and a lot of intrinsic value that we would rather not pay for. So you don't need to find a delta of 1.0 but should get close, and the 0.80-0.85 range will suit your needs. On the other side, if you buy a higher strike, there is too much time premium in the option and it may not respond to smaller changes in the stock price.

Tip 1
You can create an option-based portfolio, with 1 to 3-month expiration options of stock/ETFs, selecting the correct (ITM) call or put, depending on your bias, with a delta greater than 0.80. Finally, it's about the same as a classic portfolio with stocks and ETFs, but with all the advantages described above. Rebalancing (rolling up/down it) every month is a key in the current complex market.

Tip 2
And if you like long-term positions longer than a year, consider for your portfolio the use of LEAPS options, better on stock/ETFs with a price below $20. In this case, search for its ATM/OTM call or puts, due to its lower premium.

Use (Bullish) Credit Put Spreads

As you know, trade options are more complicated than stocks. You need to guess not only the direction of the stock but also how quickly the stock's price will get there (the speed). We can combine two concepts for a solution, selling puts and the vertical spreads, to create a great strategy, the bullish credit put spread.

- You can create a bullish trade not only by buying calls: you can sell puts. A short put, being on the opposite side of a trade of a long put, is bullish. Most traders, who are bullish, are tempted to immediately reach for the long calls, also due to its unlimited gains, but they need the stock to move. A short put also makes money if the stock rises. And more important, also make money if the stock standstill. It's a big difference that by selling puts you don´t need the stock rise for us to make money: you just can't have it fall. You eliminated the speed component of the option.

- Sell puts creates an unlimited downside risk that you could control by creating an option spread, that's combining two different option strikes as part of a limited-risk strategy.  This is called a vertical spread, consider buying and selling a call, a call spread, or buying and selling a put, a put spread, of the same expiration but different strikes Essentially, trading put credit spreads is very similar to the short put. Preserves its advantages, but without its dangerous downside risk. And that's great!

A vertical spread can be bullish or bearish and can be for a debit or a credit. Let's review my favorite of all, due to its many great features, the credit put spread.

Click to enlarge.

Typical P/L (profit/loss) chart of an ITM credit put spread. This month I'm bullish in silver (follow by the ETF SLV), now trading at $16.77. The spread was created with two legs: sell put 17 and buy put 16, for a net credit of $0.49. If SLV rallies, the put credit will decrease in value and result in a profit. Conversely, a sell-off results in a loss. As max-gain is similar to max-loss ($500), we had a good risk/reward ratio of 1. When the expiration date is near, the spread will benefit from theta decay, unless legs are completely ITM. 

As you verify in the chart above, a credit put spread has important features advantages against other option strategies. Let's summary them:

- Maximum profit: limited, and is the credit or premium received.

- Maximum loss: limited, and is the difference between the two strikes minus the premium received.

- Risk Level: low, if you use a Risk/Reward ratio near 1.0 or less. You could get it with one ATM strike and the other slightly OTM.

- Break-Even: is the strike price of the short pull minus the premium received. You will be in profit if the stock price is above this level: If move below the break-even, you will be in losses. As it's a bullish trade, the lower the break-even, the higher probability your trade will end in a profitable trade.

- Environment: ideal when you have a bullish, neutral, or slightly bearish position and don´t need a great move in the stock price.

- Legs: two, a bullish short put (the main) and, further away, a bearish long put (the protection).

- Goal: receive credit and hope both legs expired worthless, or the same, the stock price stays above the short put strike, as you can review in the chart above.

- Stock Volatility: as it affects both legs at the same time, its effect is mitigated.

- Implied Volatility: in terms of cost, for high IV (high premiums) buy a cheaper spread Buy OTM Put/Sell ATM Put. For low IV (low premiums) you can buy an expensive spread Buy ATM Put/Sell ITM Put.

- Time decay: acts in favor of a put credit spread, as short put gains with the passage of time, and its theta offsets the long option theta.

- Close Position: as other options, a spread could be closed at any moment, better prior to expiration if it reached its max-profit or your support/resistance target. Sometimes you only need to close the short put since it can't gain more and leave the long put in case it rises. And if you reach the max loss, wait: always there's a chance that the position turn in your favor.

- Stop Loss: it's usually a topic of discussion. I believe that since debit (or ITM credit) spreads are strategies that already have a lower risk defined and assumed, a stop loss isn't necessary when opening the position. A sudden change in volatility in just one of the legs can take you out of the spread immediately. With OTM credit spreads it's different due to its usual major risk/reward: I usually place a one-stop-loss (for the whole spread) set to trigger at a net loss of a minimum of 2x the initial credit.

- Expiration Risk: be careful if the underlying expires within the short and long strikes, or the short ITM and the long OTM. You have the obligation to buy 100 shares of stock for each short put. If buying power isn't enough it will activate a margin call from your broker. Remember the theory: long options have rights, short options have obligations.

For a slightly bullish bias in a stock that is consolidating in a range after a nice trend and creates strong support, all in a high-volatility market environment, consider the spread Buy OTM Put / Sell ATM Put, using a level near that support level for the higher strike price. The other leg also called the protection, that's the lower strike price, is determined by the maximum risk you can accept. 
This called OTM credit spread may not have a high reward-risk ratio (usually below 1 in this case) but it has a pretty high win rate. Using in a short expiration period (1 month, ideal) you also have time decay working in your favor. As you see, technical analysis is crucial for trade credit spreads.

Selling options strategies with a favorable risk-reward and a high probability of success is the way an Income Trader works. Think like them and treat your portfolio as an insurance company: they live selling policies (options) for a premium, a successful business. And better in high implied volatility environments. The goal is to do the same: collect as much premium income as possible and never pay out the policies. 
So, maximize the number of credit trades, diversifying between index, ETFs and stocks, in different sectors, through bull or bear market conditions, analyzing only the stock direction. Now that brokers offer commission-free trades, it's reasonably possible.

In a next Trader Notes, we take a step forward with another popular risk-defined option strategy, the iron condor, that combines two credit verticals (a bearish call spread and a bullish put spread), for use when you have a neutral bias in the underlying.

This practical chart summarizes what options strategies work better depending on market direction and implied volatility size. 
- If the market is in a low-volatility environment, use a Debit Spread, that's a call spread (buy call ATM/ sell call OTM) if you're bullish, or a put spread (buy put ATM/ sell put OTM) if you're bearish.
- And if the market is in a high-volatility environment, use Credit Spread, that`s a put spread (sell put  ATM, buy put OTM) if you're bullish, or a call spread (sell call ATM/ buy call OTM) if you`re bearish.
Straddle, Strangles, Butterflies, and Calendars are not treated in this post, but in some next.