When people want to dip their toes into options, so often they start with buying single leg options because it seems simpler to grasp. But what they don't realize is that they're playing a losing game and when the market moves against them, the results can be disastrous. Counter-intuitively, more complicated option strategies are actually safer and provide higher probability of winning. When you create spreads with options, you can achieve what we call "defined outcome investing."
Institutional investors and the top 1% have been using defined outcome investing products for decades (in the form of structured notes and annuities and more recently unit investment trusts and exchange-traded funds). Retail investors should have access to the same tools to achieve less risk and a defined return on their investments in the market.
How Does Defined Outcome Investing Work?
First, let’s define some terms that are relevant to the apparatus of defined outcome investing:
- Reference asset: Each defined outcome investment is linked to the performance of a reference asset e.g. SPY (S&P 500 Index) or QQQ (NASDAQ-100).
- Reference price: This is the price of the reference asset or market index.
- Outcome period: A defined outcome investment is not infinite. It is an option contract with a set time period. Unlike long-term investing which you must think in terms of decades to see return, this type of investment is suitable for shorter term gains.
- Cushion: The cushion is the amount the underlying asset price can go down before you lose any of your investment. In other words, this is the amount of safety blanket you have for your investment against the market.
Example: If the market index reference asset falls by 18%, but your defined outcome investment has a cushion of 15%, then you will only lose 3% overall. The buffer has absorbed most of the decline. Some popular cushions are set to 9%, 15%, or 30%.
- Ceiling: The ceiling is a cap on the maximum amount of profit you can receive as the underlying reference asset price goes up. You are capping your upside in exchange for the cushion.
Example: Say that the reference asset price soars by 35% but your upside cap is 30%. You would collect up to the first 30% of the reference asset’s increase, and miss out on 5% of the gain.
When you combine these concepts into a defined outcome investment strategy, you can create security for your investment, even during market volatility. The contract of the defined outcome investment is set for the outcome period. You can withdraw early and re-allocate your capital if the value reaches your target profit earlier.
What Are the Benefits?
- Customizable risk-return profiles
With defined outcome investing, you can personalize your risk-return profile to align with your long-term strategy. You can be conservative or aggressive. Your cushion can be set to absorb downside volatility while keeping your ceiling high enough to help you reach your financial goals. Or you can elect to have no cushion with accelerated gains in exchange for a ceiling on the profit.
- Income Generation
You can define certain outcomes to provide a fixed return that is superior to bonds and CDs while taking on a reasonable level of risk.
What kind of Outcomes can be Achieved?
There are three main objectives that can be achieved with defined outcome investing:
Best for investors who want to preserve capital, even during a market draw down.
The preservation strategy offers maximum cushion and a fixed return. The drawback to this strategy is that the ceiling is typically lower than with other strategies. Put spreads are commonly used for this objective.
Example options strategy on Ford ($F): This strategy nets a fixed 11% (19.08% annualized) profit unless F falls more than 25% to below $10.00 through expiry.
Buy 4 $9 put
Sell 5 $10 puts
Best for bullish investors who want to accelerate profits
The growth strategy is on the opposite end of the spectrum in terms of risk. There is typically no downside protection, but in exchange for the ceiling you get accelerated profit.
Example options strategy on Apple ($AAPL): This would accelerate gains by 3.2x and makes up to 20.8% (34.7% annualized) on $AAPL through 9/16/2022.
Buy 2 $160 calls
Sell 2 $170 calls
Sell 1 $170 put
Best for medium risk, medium reward investors with long term goals
This is the meeting of the two above strategies and is the most popular for defined outcome investing. You set a ceiling and a cushion that keeps your investment within parameters that match your objectives and outlook on that asset.
Example options strategy on Lucid Motors ($LCID): This strategy can make up to 17% (35.42% annualized) and only start to lose if falls by more than 62% through expiry.
Buy 1 $17 call
Sell 1 $20 call
Sell 1 $7 put
Overall, defined outcome investing is a brilliant way to grow your wealth for long-term goals with lower risk. Join Olive to add strategies like these to your investment portfolio. We are making it possible for beginners to change their approach to options trading and even out the playing field.