Applying risk management to your vanilla equity portfolio does not have to be complicated. Here is an example to illustrate how a short option overlay strategy can work.

Suppose that you own 1,000 shares of XYZ stock, which is currently trading at $50 per share. You are bullish on the stock and believe that it will continue to rise in the near term, but you are also concerned about the risk of a potential downturn. To protect against this risk, you decide to implement a short option overlay strategy.

First, you sell 10 XYZ put options with a strike price of $45 and an expiration date of three months from now. The premium received for selling the options is $2 per share, or a total of $2,000 (10 contracts x 100 shares per contract x $2 premium per share). By selling these put options, you have agreed to buy 1,000 shares of XYZ stock at $45 per share if the price falls below that level by the expiration date.

Second, you sell 10 XYZ call options with a strike price of $55 and an expiration date of three months from now. The premium received for selling these options is also $2 per share, or a total of $2,000. By selling these call options, you have agreed to sell 1,000 shares of XYZ stock at $55 per share if the price rises above that level by the expiration date.

That was easy, right? You can use diversification and dollar cost averaging, but sometimes the best risk management method is to use derivatives.

Need more explanations?

Now let’s consider some possible scenarios for an investor that uses derivatives according to our example above:

Scenario 1: The stock price stays between $45 and $55 by the expiration date
In this scenario, neither the put nor the call options are exercised, and the investor keeps the entire $4,000 in premiums. The investor has effectively hedged against potential losses if the stock price drops below $45 or if it rises above $55.

Scenario 2: The stock price falls below $45 by the expiration date
In this scenario, the put options are exercised, and the investor buys 1,000 shares of XYZ stock at $45 per share. However, the investor still keeps the $2,000 in premiums received from selling the put options, which helps to offset the cost of buying the shares. The call options are not exercised in this scenario, as the stock price is below the strike price of $55.

Scenario 3: The stock price rises above $55 by the expiration date
In this scenario, the call options are exercised, and the investor sells 1,000 shares of XYZ stock at $55 per share. However, the investor still keeps the $2,000 in premiums received from selling the call options, which helps to offset the potential gain of selling the shares at a higher price. The put options are not exercised in this scenario, as the stock price is above the strike price of $45.

In summary, a short option overlay strategy involves selling both put and call options on an underlying asset to hedge against potential losses while still benefiting from potential gains in your vanilla equity portfolio. The premiums received from selling the options can help offset any losses in the underlying asset, while the short options act as a hedge against potential downside risk. It’s important to note that this strategy does involve risk, and careful consideration and monitoring of the options positions is necessary to ensure that they are effectively hedging against potential losses. It is also worth mentioning, that the use of derivatives can be very expensive as most banks charge a premium for the service.