Risk Management in
Option Income Investing
Option income investing can help control investment risk for affluent investors and families.
Investment risk describes the potential that your portfolio will decline in price or be more volatile than you expect or can withstand.
As a high-net-worth investor, you may own option income funds through mutual funds, ETFs, separately managed accounts, and retirement accounts in your portfolio.
Investment risk is everywhere. Risk can be caused by macroeconomic issues—economic, market, political, and geopolitical risk. Risk can also come from increased inflation, changes in interest rates, credit defaults, and currency fluctuations, among others.
A risk management philosophy focusing on hedging, selecting the right securities, and regularly monitoring a portfolio may reduce the risk of potential stock price declines and unwanted price declines and market volatility.
Risk can be caused by macroeconomic issues—economic, market, political, and geopolitical risk. Risk can also come from increased inflation, changes in interest rates, credit defaults, and currency fluctuations, among others.
Controlling Risk Though Option Income Investing
Option investment hedging strategies may be designed to minimize investor losses and increase in value when stock prices drop.
Options can also provide leverage. Option investors typically pay a small fraction of the securities’ price to own the stock. An investor can see large percentage gains from comparatively small, favorable moves in the underlying stock. However, leverage may be bad for investors. Leverage increases investment’s loss if the underlying stock price does not go up or down as thought.
Mitigating Risk: Own the Right Securities
Buying the right securities is a primary risk management tool.
Selecting individual businesses of profitable companies with strong fundamentals and experienced management is among the most important considerations in managing risk. Buying the right securities with the best risk-return profile is also critical for producing an investment premium with minimal price fluctuation. Trading decisions based on personal experience and education rather than by algorithm are also primary for many.
Some investment managers simply look for opportunities and risks that others may not see.
Reducing Risk: Know the Right Way to Hedge
Moreover, for many investment managers, knowing the right way to hedge options may reduce potential volatility and loss of principal and income created by unknown and uncontrollable forces.
Hedging techniques based on fundamental and technical analysis of a business may include buying or selling puts or calls, creating collars, or a variety of spreads on a combination of securities.
Cushioning Risk: Monitor Your Investments
Actively monitoring option positions may also help reduce risk.
Conducting rigorous market postmortems at the end of an option cycle is a strong consideration in managing risk and understanding what might happen. This analysis may include what got called away and what didn’t and preparing for what might happen in the next cycle.
Knowing the right way to hedge options may reduce potential volatility and loss of principal and income created by unknown and uncontrollable forces.
Understanding Macroeconomic Risk
Understanding macroeconomic factors—economic data, stock market momentum, market sentiment, geopolitical issues, political machinations, and more—is part of a disciplined hedging process. Knowing the big picture can help to identify how and when hedging may be appropriate. Critical risks include:
Economic Risk. Economic risks are the financial risks (unemployment, recession, inflation) that impact the economy.
Geopolitical Risk. Portfolio problems caused by geopolitics can create chaotic markets and issues for investment managers and their clients. Geo risks include terrorism, wars, political shenanigans, trade and tariff troubles, and regulatory changes.
Market Momentum Risk. Does momentum matter? Yes. Trends are not permanent. The market constantly changes direction, and may result in potential losses for momentum investors.
Market Sentiment Risk. Market sentiment is the behavioral attitude of how investment crowds make investment decisions.
Political Risk. Politicians and their policies can create headaches for investors. The risk of political decisions on the market can painfully affect the prices and values of securities.
Understanding Portfolio Risk
An investment portfolio may also be destabilized by economic risks like credit, liquidity, and interest rate risks. Knowing the impact of these risks on a portfolio may help reduce the risk of potential stock price declines in deciding what options to own. Examples:
Credit Risk. Credit risk analysis assesses a company’s ability to repay creditor’s money. It considers factors like cash flow, fixed expenses, and operating margins.
Liquidity Risk. Liquidity risk is the possibility that an investor will have difficulty selling their investments for cash when and where they want to.
Inflation Risk. Inflation eats money. A 3% inflation rate over 30 years of a $1 million portfolio of investable assets would be worth only $655,000. Inflation can make thousandairs out of millionaires.
Interest Risk. Interest rate risk is the possibility that interest rate changes will decrease an investment’s value.
Price Volatility Risk. The pain of price volatility is that assets can decrease more than an investor’s comfort level. How many investors would be ok with a $1 million portfolio decrease to $800,000 or less in 90 days? Educated long-term growth-oriented investors, for example, may feel unharmed if their portfolio decreases, say, 20% in three months, because they understand that their portfolio may have downs and up, but ultimately the ups may outperform the downs.
The pain of price volatility is that assets can decrease more than an investor’s comfort level.
Risk Management: A Positive Tool
Risk management through option investing can be a positive tool for investors.
Option income investing can help minimize an investor’s risk by owning the right securities, knowing the right hedging strategies, and understanding the many factors comprising macroeconomic and portfolio risk.
About Solidarity Capital
Solidarity Capital is a boutique asset management company and investment fund manager focused on delivering monthly income to investors using a proprietary investment strategy. Based in Lehi, Utah, Solidarity is led by our founders, Jimmy Mortimer, Jeff McClean, and Zach Whitchurch, entrepreneurial thinkers and doers.
About Jeff McClean
Jeff McClean, Managing Partner of Solidarity Capital, brings a unique perspective to the Solidarity Capital investment team. Jeff leads fundraising, fund administration, investor relations, product development, and contributes to the strategic investment direction of Solidarity Capital. He earned a bachelor’s degree in accounting from Brigham Young University–Idaho, and a Juris Doctor, with honors, from the University of Texas School of Law.