Defensive Strategies with Sales Options (Puts) allow you to optimize yields in the downward phases of the Market.
We will emphasize the Options, among the many Defensive Strategies available, just as we did when analyzing aggressive ones.
It is also common to use other means, such as:
Decrease the percentage of risk assets in your portfolio
Stop the leverage of your risk position by canceling debt
Choosing lower-risk assets to integrate your portfolio
We prefer to use the sales options, as they offer us a wide potential for profits but limited losses.
When we buy options (Puts), we pay a price (called a premium), and that price is all we can lose if the chosen time is wrong.
When to start Defensive Strategies with Options?
The answer depends on the method of analysis you have chosen to decide your investments, such as aggressive ones.
You can use technical, fundamental or academic analysis.
In the first two cases, you seek to find «expensive» and «cheap» levels, either in the general market or in certain assets in particular.
So you’ll be defensive when you identify «expensive» assets or are on a downward trend.
Instead, when you use the academic approach you give up trying to predict the market, and you only adapt to it.
Let’s detail examples of Defensive Strategies with Options based on academic analysis, which is the one we prefer.
Under this approach, we will be defensive when our RISK indicates it.
Our attitude towards risk forces us to be cautious when the risk expected by the market increases (measured by implied volatility).
In addition, we must take defensive action when our risk capacity decreases.
This occurs when our previous yields have been negative, and we need to limit the risk of incurring higher losses.
Case Analysis: Our Investment Policy
Let’s take a closer look at an example, which can help you generate your own Defensive Strategies with Options.
Our investment policy is based on data so specific and measurable that it is expressed in financial algorithms.
So our Strategies respond to objective and systematic patterns.
Our policy is based on passive investment in the best portfolio we find on Wall Street: QQQ, the ETF created by Invesco to emulate the Nasdaq 100.
When faced with a possible bearish phase of the market, we need to execute strategies that protect our investment in QQQ.
AL SIMPLE’s investment algorithms will never tell us to sell our position in QQQ.
But they will alert us to the start of defensive strategies more often than aggressive ones.
The reason is simple, we are already aggressive always maintaining our position purchased in QQQ, and our constant search is balance.
Next we will see these strategies, disclosing their triggers and their instruments (calls and puts).
Finally, we analyze the results achieved and the frequency of this operation.
Defensive Strategy Triggers with Options
As in aggressive strategies, we have two triggers in our algorithmic trading:
The Performance of Our Portfolio
The Risk of Our Portfolio
When the performance of our portfolio in recent months is negative, we want to limit our chances of loss.
We know we’re at a bearish stage of the market, although we don’t know if it will continue.
What we do know is that we have no room to assume greater losses.
That’s why we execute defensive strategies.
If they go wrong, it’s because the market goes up, and the cost of strategies will be offset by the rise of our position in QQQ.
We’re always going to take limited risks.
We are also cautious when the risk that the market observes in our portfolio increases significantly.
That risk is constantly measured by the VXN volatility indicator.
When we appreciate that increase, we execute a defensive strategy, since objectively (VXN is a market price) the risk of low market is higher.
Calls & Puts
For these strategies we almost always use sales options, and occasionally the sale of buying options.
When the foundation of caution originates from yields, we will use both instruments:
Sell purchase options
Buy sales options
Our risk is always limited.
When we sell purchase options, we are always covered by our position in QQQ.
When the cause is an increase in volatility, let’s buy selling options.
Again, our risk is limited to the price we pay for the option.
Let’s look at an example with QQQ trading at 300.
In the event of a defensive trigger, an indication such as the following will be generated:
A. Buy a put at the 295 exercise price, due February 10.
and sometimes this instruction will be accompanied by:
B. Sell a call at the 305 exercise price, due February 15
From the moment of the transaction, our algorithms will measure market behavior, and indicate when to terminate the strategy, reversing trades.
Completion will be because you have reached a performance goal, because you have reached a maximum loss limit, or because the option is short of time to expire.
If the scenario to be cautious is maintained, by yields or risks, the day after completing a strategy, the instruction to start it again will be generated, although the exercise prices and maturity times will be different.
As it is an algorithmic trading approach, before starting the implementation of our policy (in 2019) we backtested its effectiveness.
These were the average annual yields for the period 2007-2018:
On average, we start 17 strategies per year.
So we must have the expectation to trade 34 of the 250 trading days of the year.
If we add this amount to the 28 of the aggressive strategies, it is 62 trades per year, once every 4 days.
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