Barron’s ran an intriguing feature in an August issue titled: “Options Funds for a Nowhere Market.”
The story explains how many respected analysts have projected annual S&P 500 returns over the next decade to average just 1.1% after inflation and how writing options in a portfolio can help generate income, even if the market goes nowhere.
It goes on to point out that Morningstar has finally broken out options funds into their own category, noting, “The media is finally catching on to what a growing chorus of mainstream investors already know: Selling options can be a solid path to creating wealth – regardless of how the underlying market performs.”
It is encouraging that the broad business media is finally catching on to the value of options. As we head into 2017 the strategy is becoming more institutionalized. Morningstar currently lists 45 funds under the category of “options funds.”
But there is one glaring omission in the piece. While the author touts the value of including options funds to enhance performance in flat markets – he fails to mention a diversification aspect.
The reason for that is there is no diversification. You see, the strategies and funds this piece explores are certainly attractive and worth pointing out to the non-initiated, but they are all strategies incorporating stock options. If you buy into one of these funds, you may indeed be able to target higher returns in a flat stock market; but you are still in the stock market. You may be diversified from outright shares, but you’re still in the same asset class. Your portfolio will still be affected by everything that affects stock prices: Earnings, geopolitical news and the whims of the Federal Reserve. That’s not really diversification.
It is possible to enjoy the potential fruits of selling options in an asset class completely uncorrelated to equities. Commodities tend to get second billing in mainstream financial publications, but offer unique attributes in an option writing strategy.
Commodities options offer option sellers the ability to apply their strategy to a completely uncorrelated asset class. This can provide a valuable diversification component to any portfolio – but especially for higher net worth investors.
While equites tend to move together causing periods when premiums are low causing options sellers to take on greater risk, commodities have seasonal tendencies creating periods of increased volatility and premium value. Traders can fish for markets with higher premiums instead of being locked into low-volatility equities, which force sellers to either be out of the market or get closer to the flame. But there is a second reason – one that clearly works to your advantage.
Paul Meister recently attended a dinner party hosted by Worth magazine in Parrilla, Argentina. What does this have to do with you? Mr. Meister is vice chairman of GCM Grosvenor, a $48 billion global asset management firm.
For a whale like this to move through the markets, he needs ocean-sized volume in the assets he trades. Options offer a smaller universe of open contracts. However, in stocks, even if one limits himself to S&P 500 stocks, there are 500 potential stocks on which to sell options. This doesn’t even count shares outside of the S&P or options on indexes. That gives wide enough birth for behemoths like Meister, Icahn or even Buffet to engage.
In commodities futures, there are only about 15-20 markets with enough volume to effectively write options on a larger scale. And that includes financial markets like the S&P 500 futures and Treasury bonds. While their individual volumes of options are typically much deeper than the average stock (options on major markets such as oil, gold or soybeans is huge), there are not 500-1,000 different markets from which to choose.
In short, there is simply not enough room in the commodities options markets for big funds such as this to operate. In addition, commodities — especially the physical commodities such as corn, gasoline or coffee — are typically specialized fields, outside the expertise of most stock analysts.
This means less competition for you as an option seller. Commodities options are the domain of individual specialized traders or targeted, boutique funds or managers – able to move in and out of positions nimbly and adjust to changing conditions quickly.
Goliaths like Meister typically cannot do that on a scale big enough to make it worth their while, which is why you, or a specialized portfolio manager, have an advantage. You can get the diversification that they can’t. But you can also get it without having to compete with multi-billion dollar fund managers.
Barron’s got it right on the first part and should be applauded for finally starting to give its readers more exposure to options alternatives. The next step will be to introduce its readers to a more diversified options playing field.