Options vs Mutual Funds for Wealth Creation

Personal finance has taken on a prominent role in public discourse in recent times. With the advent of the internet age, public access to financial instruments like mutual funds, bonds, equities, futures & options, currency derivatives as well as unconventional assets such as cryptocurrencies has increased exponentially.

However, the advice that was prevalent in the 1990’s still does the rounds regularly.

Invest your money in mutual funds and enjoy the power of compounding

It can’t be denied that this advice has a lot of weight to it. Value investing and compounding has made a lot of money for a lot of people. However, this philosophy of investing has a few pitfalls as well.

1.  Overdependence on Fund Managers: People usually look on the very long-term time horizon while evaluating a mutual fund scheme. This can range from 20 to 30 years. However, fund managers come and go and past performance of a mutual fund has low correlation with fund performance in the next 5 or 10 years. It is idealistic to expect that a fund will be able to give consistent 10-15% returns in these times of unprecedented market movements and recession like conditions.
2. Delayed Rewards: It is often said that delayed gratification is a good thing. Nonetheless, is it really ideal to receive a few crores when you are 50 or 60? Or buying a house or two at 35 and then having to start your investing journey all over again since you extinguished all your capital. Your glory years are behind you and you already spent your 20s, 30s and 40s cribbing and saving every penny. Compounding when the return on investment is 10% only works if you stay invested in the long term. People have different priorities; however, I’d not describe spending your golden years living a bland, colourless life as ideal.

Times have changed and the educated investor has many ways to grow their wealth rather than depending on a fund manager. We’d like to highlight one of those methods, Hedged Options Selling.

A basic understanding of options taken from Investopedia is given below:

The term option refers to a financial instrument that is based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they decide against it. Each contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price.

A person who writes or sells these contracts is known as an option seller.

Options spreads are strategies that use various combinations of buying and selling different options for the desired risk-return profile. Spreads are constructed using vanilla options, and can take advantage of various scenarios such as high- or low-volatility environments, up- or down-moves, or anything in-between.

An experienced and educated options trader can easily beat any mutual fund out there and provide a consistent return of 30-40%.

It is especially telling that even Warren Buffet’s gargantuan trading company; Berkshire Hathaway sells naked options when a stock is overvalued.

 From here onwards, we would like to highlight some of the pros, myths and cons of option selling.'

Pros:

1. Fantastic Returns: Option selling is a relatively safe way to generate 30-50% returns for an educated investor. You can capture premiums of at least 100-200 points on a weekly basis and the number of lots you can buy increases weekly. In comparison to that, capturing such up moves regularly in equities is equivalent to a black swan event.
2. No requirement to time the market: It is often said that timing the markets is impossible. Options completely remove the need for that. You don’t need to worry about buying the dip when you can make money in all market conditions. The true power of option selling is apparent during flat market conditions, which are predominant throughout the year and can’t be exploited by other financial instruments. You can make money during volatile times as well by applying the correct options strategy.
3. Get paid regularly: Long term vehicles of investment require you to stay invested and keep on investing at regular intervals. You don’t get to see your money until a decade or two has passed. With index options selling you get paid on a weekly basis, 52 times a year. Stock options pay out on a monthly basis. You can take out as much money as you need for an emergency without causing damage to your financial health.  
4. Be your own master: A significant portion of the earnings from a SIP or Mutual Fund is spent in paying various fees and charges. You don’t have any control over your own money either. With options selling, you can bypass the fees charged by the fund house and transact with the markets directly.
5. Easy risk management: Options were primarily designed to act as a risk management instrument. It is only in recent times with the advent of algorithmic trading that options have taken on the role of being the riskiest financial instrument available to the general public. However, while selling options you can still utilize the risk management properties of options to great effect. For example, you can apply a very simple spread for every trade you take. If you are bullish on a stock, you sell a put and buy a far out of money strike put for protection. This way, even if the stock moves downwards in a heavy manner, your losses are capped. Moreover, in case the market is volatile, you can choose to apply buying strategies like a long straddle in order to make great returns. Ultimately, the sky is the limit.
6. Stress free income: A strong options system requires minimal management. You are able to generate excellent, low effort and consistent income on a weekly basis once you are able to set a strong system in place. Remember that time is on your side! Keep your mind and heart healthy and at peace.

 Having elucidated the pros of option selling, we’d like to bust some myths that have spread like wildfire in the markets.

Myths:

1. Option selling has unlimited losses: I find it extremely ironic that people say that option selling has unlimited losses while mentioning in the same sentence that option buying has limited losses. If that was the case, why would anyone bother placing a stop loss on option buys? The truth is that while buying options you need to be correct about both, trend and timing while option selling only requires you to be correct about the trend. Moreover, it is frankly weird to say that options selling has unlimited losses, because you are wilfully ignoring a vast number of creative option strategies that serve to mitigate risk. It is cheap to buy protection while selling options. A careless trader will always make losses, while a trader utilizing spreads correctly will generate wonderful returns.
2. Only experts can trade in options: It is true to an extent; however, any person can educate themselves enough to become a profitable options seller. You don’t need a CFA or MBA to sell options. The only requirement is a will to learn and improve. Becoming an expert is not out of the realm of possibility!

And finally, moving on to the cons of option selling:

Cons:

1.  High initial capital: Selling options usually requires you to have enough margin to ensure that if the option is exercised, you can deliver/buy the underlying. Consequently, it costs nearly a hundred thousand rupees to sell any option in the market. It is hard for a new trader to accumulate a decent capital so that good profits can be generated via selling.
2. Education and Experience mandatory: It is not possible to become a good options seller without educating yourself. Similarly, without experience in the markets you can’t make educated decisions. Attaining this requires a heavy time investment.  
3.  Strong personality needed: If you choose to sell options, you need confidence in your own ability. You need to have the self-esteem to take control of your journey for financial independence and you cannot let critics lower your morale.

I sincerely hope that I have been able to generate some curiosity in you to attempt to enter the options arena. It would be an honour for me if this article was of some use to you and your financial journey.