Derivatives such as options enable investors to exchange specific market risks in their portfolios in much the same way homeowners who need fire insurance can purchase it from companies that pool risks to provide that coverage.

In its basic form, an option contract gives the purchaser the right to buy (or “call”) or the right to sell (or “put”) an asset by a future date at an agreed-upon price. Many factors determine options pricing, but the most important is the implied—or expected—volatility of the underlying security over the life of the option. When expected volatility escalates, the option’s price increases because the statistical probability of that option gaining more intrinsic value rises. Inversely, when expected volatility falls, the option price declines, reflecting falling probabilities of the underlying asset moving enough for the option to gain more intrinsic value. (For more insight on options pricing and implied volatility, see our latest Hedge Fund Monitor.)

Institutional investors can use three primary options-based strategies to shape their risk: buying insurance, selling insurance, or otherwise trading insurance to capture mispricings of these contracts.

Overexposed to Downside or Upside Risk? Buy Insurance

Under special circumstances, investors may need to hedge against future losses by buying out-of-the money puts. For example, if an investor has an unusual short-term liability that needs protected funding, then put options are appropriate to consider as a risk management tool. Similarly, others who are materially underexposed to, or short, a particular market risk may need to hedge against a short-term melt-up scenario by buying out-of-the-money calls.

Except under unusual circumstances, buying insurance normally involves an expected loss. Consequently, for investors with long-term investment horizons, constantly paying for options-based hedges is not an appropriate strategic investment; such investors with uncomfortable levels of market risk should simply reduce those strategic risks.

Interested in Monetizing Uncertainty? Sell Insurance

For the investor willing to accept downside risk or surrender upside risk, selling such insurance is an incremental income strategy that can generate better risk-adjusted returns. The most common options-based trade for selling insurance on upside risk is known as a covered call; the equivalent trade for selling insurance on downside risk is called a put write. The key to success in underwriting such risks is a long-term commitment. While losses occasionally incurred from writing insurance can be very painful, harvesting the higher premiums available after such losses is critical to the long-term profitability of this strategy.

Investors who systematically implement rebalancing policies to move portfolio allocations back to a strategic asset allocation target are good candidates for customized option-writing strategies. For example, when an investor’s equity allocation moves to the high end of its target allocation, selling calls on that equity exposure effectively monetizes the excess volatility premium from upside risk while committing the investor to shed any further equity gains. Similarly, when the equity exposure is at the bottom end of its target range, selling puts captures that downside risk premium while committing the investor to bear more equity risk, per its rebalancing policy, if equities trade lower. Assuming that the implied volatility premium over realized volatility is positive, this options-based rebalancing strategy improves the investor’s odds of enhancing its risk-adjusted returns.

Interested in Diversifying Strategies? Hire an Expert

For those investors looking to diversify a portfolio full of traditional market risks, many options-based strategies exist to take advantage of either structural or temporary mispricings across the derivative markets. Such investments can be treated as distinctly separate allocations that are normally less correlated, or even uncorrelated, with other risk assets.

Diversifying strategies based on options come in two different flavors:

Volatility Arbitrage relies on one-off arbitrage opportunities where expensively priced options are sold while more cheaply priced options with offsetting risks are purchased. This strategy is the most difficult to execute profitably and hardest to replicate systematically. Not surprisingly, for the level of expected net returns from this strategy, the cost of implementation can be a relatively high percentage compared to other hedge fund strategies. Finally, because of its reliance on idiosyncratic risks while hedging significant systematic risks, it is perhaps the most difficult for investors to measure and monitor.

Hedged Volatility relies on a systematic, or rules-based, trading strategy of harvesting volatility where this risk premia is most significant (i.e., at-the-money options) while buying protection (i.e., out-of-the-money) against low-probability events that help the investor with gains to offset the worst-case scenarios of losses that can often impair the strategy’s volatility-selling component.

Given the highly liquid and efficiently priced markets for this type of insurance trading strategy, the capacity for assets managed is significant and therefore pricing is often very competitive, without a compelling need to pay incentive fees, especially those strategies with more systematic, or rules-based, implementations. However, the hedged volatility strategy does involve greater skills to hedge systematic risks and isolate the alternative risk premia of implied over realized volatility, so implementation costs will be higher than those of simply selling or buying insurance.

Using the full array of options across all markets, investors can effectively control outcomes. Of course, there’s a catch. Because derivatives, like most liquid markets, are efficiently priced, no easy free lunch exists. Furthermore, when the boundaries of measured risk are tested and markets become irrational, we find that risk management is as much an art as it is a science. However, depending on prevailing market forces and an investor’s risk appetite, reshaping outcomes with options can still be worth considering.