An Options Strategy For Higher Returns Than Equity

Investing is a tradeoff between risk and return. There’s a slider you can drag to the left to make your portfolio less risky, but have less returns. Or right to increase returns while taking on more risk. As you drag the slider right, equity becomes a bigger and bigger part of your portfolio, till it hits 100%.

But what if you want higher returns than 100% equity can provide? You want to move the slider past the end.

Here’s a strategy to help you achieve that, assuming you’re willing to accept higher risk and have a longer time horizon. We’re also assuming you don’t want to take a position regarding any sector, cap size, theme, country, etc — you want to remain as neutral as possible.

The basic strategy is to buy index options, specifically call options, to bet that the index rises more than its historical average.

Let’s unpack that statement:

Selling options is dangerous because it can open you up to an unlimited downside. But buying them is safe — you can lose no more than what you invested.

You want to buy options on the index, rather than individual stocks, because you want to invest in the whole market.

In India, the long-term returns from equity have been 18%. So you’re looking for a strategy that returns more than 18% over a long term. If you’re content with an 18% return, stop reading this blog post and just invest in stocks via a mutual fund, ETF or index fund.

If the index is at 100, buy a call option with a strike price of 101.4 with a maturity of 1 month. You’re betting on at least a 1.4% monthly return, which is an 18% annual return. If the market rises by more than that in a month, you exercise your option, buy at 101.4, sell at the market rate, and make a profit.

Buy another option with a maturity of 2 months, and the same annualised interest rate of 18%, which amounts to a strike price of 103, assuming again that the index is at 100 today.

Buy a third option with a maturity of 3 months and a strike price of 105.

You similarly buy options with various maturities, because you don’t know when the market will rally.

If possible, buy American-style options rather than European-style ones. The former let you exercise any time till maturity, while the latter let you exercise only on the date of maturity. The former is better because you can benefit from a rally any time, and you need options of fewer different maturity periods to cover a given time period.

If the country you live in has different indices, try to buy options on an index that covers the whole market, like Willshire 5000 in the US, because otherwise, you’re no longer neutral — you’re betting on certain types of companies, typically big ones.

Diversify outside your country by buying options on different countries’ indices.

This strategy will give you a higher return than equity, at the cost of higher risk, if that’s what you want.