Goal-based investing is an investment approach that involves setting specific goals and objectives and then designing an investment portfolio that is aligned with those goals.
The goal-based approach takes into account various factors such as risk tolerance, time horizon, and expected returns, among others, to create a portfolio that is tailored to meet the specific needs of the investor. In this blog post, we will explore how it can be applied to options trading.
Goal-based investing is an investment approach that focuses on the specific financial goals of an individual or an institution. Unlike modern portfolio theory (MPT), which is a more traditional investment approach that emphasizes diversification and risk management, goal-based investing starts with identifying the investor’s goals and then tailoring the investment strategy to achieve those goals.
Why goal-driven investing is better than MPT
There are several reasons why this results focused investing can be a better approach than MPT. Here are some of the key reasons:
- Focus on the investor’s needs and goals
One of the primary advantages of goal-based investing is that it focuses on the investor’s specific needs and goals. Rather than simply aiming for the highest possible returns, goal-based investing starts with understanding what the investor wants to achieve and then developing a customized investment strategy that is designed to meet those goals. This can help investors stay on track and avoid making impulsive investment decisions based on short-term market fluctuations.
- Better alignment of risk and return
Another advantage of goal-based investing is that it can help align the risk and return of an investment portfolio with the investor’s goals. For example, if an investor’s primary goal is to generate income to support their retirement, a goal-based investment strategy might focus on generating consistent income from high-quality dividend-paying stocks, bonds, and other income-generating assets. This approach can help the investor achieve their income goals while minimizing the risk of losing principal.
- More flexibility and adaptability
Goal-based investing also offers more flexibility and adaptability than MPT. Because the investment strategy is tailored to the investor’s specific goals, it can be adjusted over time as those goals change. For example, if an investor’s goal shifts from generating income to growing their wealth, their investment strategy can be adjusted to reflect that change. This flexibility can help investors stay on track and avoid being locked into an investment strategy that is no longer appropriate for their needs.
- Greater transparency and accountability
Goal-based investing can also offer greater transparency and accountability than MPT. Because the investment strategy is focused on specific goals, it is easier to measure progress and evaluate the effectiveness of the strategy. This can help investors stay engaged with their investments and make more informed decisions.
In summary, goal-based investing can be a better approach than modern portfolio theory for investors who want to achieve specific financial goals. By focusing on the investor’s needs and goals, aligning risk and return, offering more flexibility and adaptability, and providing greater transparency and accountability, goal-based investing can help investors achieve better outcomes over the long term.
How to apply goal based investing to options trading
To apply goal-based investing to options trading, we need to start by identifying our goals and objectives. This could include things such as:
- Generating a certain level of income
- Achieving a specific rate of return
- Hedging against market risk
- Speculating on price movements
What are the best strategies?
Once we have identified our goals and objectives, we need to design an options trading strategy that is aligned with those goals. This could involve a range of different strategies, such as:
- Covered call writing: This strategy involves selling call options on a stock that is already owned. The goal is to generate income from the premiums received from selling the options.
- Protective put buying: This strategy involves buying put options on a stock that is already owned. The goal is to protect against a decline in the stock’s price.
- Long straddle/strangle: This strategy involves buying both call and put options on the same underlying asset with the same expiration date. The goal is to profit from a significant price movement in either direction.
- Iron condor: This strategy involves selling both a call and put option at a certain strike price and buying a call and put option at a higher and lower strike price, respectively. The goal is to profit from a range-bound market.
- Calendar spread: This strategy involves buying and selling options with different expiration dates. The goal is to profit from a change in the options’ time value.
These are just a few examples of the many different options trading strategies that can be used to achieve specific goals and objectives.
When designing an options trading strategy, it is important to take into account various factors such as risk tolerance, time horizon, and expected returns.
For example, a trader with a low risk tolerance may opt for a protective put buying strategy, while a trader with a higher risk tolerance may opt for a long straddle/strangle strategy.
It is also important to monitor and adjust the options trading strategy as market conditions change. For example, if the market becomes more volatile, it may be necessary to adjust the strategy to protect against potential losses.
Let’s take a closer look at each of the options trading strategies mentioned above:
Covered call writing
Covered call writing is a popular options trading strategy that involves selling call options on a stock that is already owned. The goal is to generate income from the premiums received from selling the options.
This strategy is often used by investors who own a stock and want to generate additional income without selling the stock. By selling call options, investors can receive a premium in exchange for giving up the potential upside on their stock if the stock price goes above the strike price of the call option.
For example, let’s say that you own 100 shares of XYZ stock, which is currently trading at $50 per share. You believe that the stock is unlikely to go above $55 per share in the next few months, but you still want to generate some additional income from your investment.
You could sell a call option on your XYZ stock with a strike price of $55 and an expiration date in a few months. If the stock price remains below $55, the option will expire worthless, and you will keep the premium received for selling the option. However, if the stock price goes above $55, the buyer of the option will exercise their right to buy the stock at the $55 strike price, and you will miss out on any further upside above $55.
This strategy can be a good option for investors who want to generate additional income from their stock holdings while minimizing the risk of selling their stock at a lower price. However, it is important to note that this strategy does not eliminate the risk of owning the stock, and investors should be prepared for potential losses if the stock price declines.
Protective put buying
Protective put buying is an options trading strategy that involves buying put options on a stock that is already owned. The goal is to protect against a decline in the stock’s price.
This strategy is often used by investors who are concerned about potential losses in their stock holdings but do not want to sell their stock. By buying put options, investors can protect their stock holdings against potential declines in price. If the stock price declines, the put option will increase in value, offsetting some or all of the losses in the stock.
For example, let’s say that you own 100 shares of XYZ stock, which is currently trading at $50 per share. You are concerned that the stock price may decline in the next few months, but you do not want to sell your stock. You could buy a put option on your XYZ stock with a strike price of $45 and an expiration date in a few months. If the stock price declines below $45, the put option will increase in value, offsetting some or all of the losses in the stock.
This strategy can be a good option for investors who want to protect their stock holdings against potential losses while maintaining their exposure to potential gains. However, it is important to note that buying put options can be expensive, and investors should be prepared for potential losses if the stock price does not decline as expected.
Long straddle/strangle
Long straddle and long strangle are options trading strategies that involve buying both call and put options on the same underlying asset with the same expiration date. The goal is to profit from a significant price movement in either direction.
The main difference between the two strategies is the strike price of the options. In a long straddle, both the call and put options are bought at the same strike price, while in a long strangle, the call and put options are bought at different strike prices.
For example, let’s say that you believe that XYZ stock is going to experience a significant price movement in the next few months but you are not sure whether the price will go up or down. You could use a long straddle strategy by buying a call option and a put option on the XYZ stock with a strike price of $50 and an expiration date in a few months. If the stock price goes above $50, the call option will increase in value, and if the stock price goes below $50, the put option will increase in value, allowing you to profit from the price movement in either direction.
This strategy can be a good option for investors who expect a significant price movement in the underlying asset but are not sure whether the price will go up or down. However, it is important to note that this strategy can be expensive, and investors should be prepared for potential losses if the price does not move as expected.
Iron condor
Iron condor is an options trading strategy that involves selling both a call and put option at a certain strike price and buying a call and put option at a higher and lower strike price, respectively. The goal is to profit from a range-bound market where the underlying asset remains within a certain price range.
For example, let’s say that you believe that XYZ stock will remain range-bound between $45 and $55 over the next few months. You could use an iron condor strategy by selling a call option with a strike price of $55 and buying a call option with a strike price of $60. At the same time, you would sell a put option with a strike price of $45 and buy a put option with a strike price of $40. If the stock price remains between $45 and $55, all four options will expire worthless, and you will keep the premium received for selling the options. If the stock price goes above $55 or below $45, you will incur losses on the options that you sold, but these losses will be partially offset by the options that you bought.
This strategy can be a good option for investors who expect the underlying asset to remain range-bound over a certain period but are not sure about the direction of the price movement. However, it is important to note that this strategy can also be expensive, and investors should be prepared for potential losses if the price breaks out of the range.
Conclusion
Goal-based investing can be applied to options trading by aligning investment objectives with options strategies. The four strategies discussed in this article can help investors achieve different investment goals, such as generating additional income, protecting against potential losses, profiting from significant price movements, or profiting from a range-bound market.
However, it is important to note that options trading involves significant risks, and investors should be aware of these risks before engaging in options trading. It is also important to have a solid understanding of options trading and the different strategies available before implementing them.
Investors should also consider factors such as market conditions, volatility, and the underlying asset’s price movements before selecting a particular strategy. As with any investment, diversification and risk management are critical, and investors should not rely on a single strategy for all their investment needs.
In summary, goal-based investing can be an effective approach to options trading, but investors should be prepared to put in the necessary research and analysis to choose the right strategy for their investment objectives and risk tolerance.