Option Trading: How Important is Asset Allocation? Part II

Subtitle:  How does an individual investor reduce the volatility of an investment portfolio and avoid devastating financial losses?


Part I

Tom Lauricella, writing in The Wall Street Journal, caught my attention with two recent articles.  The first discussed whether asset allocation should still play a vital role for all investors:

"Asset allocation, a bedrock of investing for decades, appeared to fail
miserably in 2008. The conviction shared by most investors — that they
should spread their money across myriad asset classes to minimize
losses — was shaken as nearly all markets tumbled in unison…

"Many investors came away from the carnage believing that last year
was an anomaly…But a number of influential investors and analysts… argue that asset-allocation
strategies are fundamentally flawed. This wasn't a one-off failure,
they say, but one that's been long in the making."

As Tom notes, not everyone agrees.  But asset allocation is a fundamental concept.  It's part of modern portfolio theory.  Diversification and asset allocation were gospel.  Now there's some doubt.

The second article was published just four days earlier. 

Trying to develop new funds for retirees, Deutsche Bank's DWS Investments executives chose an ok strategy but they ran into problems.

"The experience at Deutsche Bank's DWS Investments …
reflects the challenge facing mutual-fund companies and life insurers
as they try to transform volatile stocks into stable investments that
offer retiring baby boomers predictable income or protection from
losses
. As if that isn’t hard enough to accomplish, they are trying to
do it at a low cost to investors and in a way that doesn’t lock up
money for years, as has been the case with many traditional guaranteed
investments such as annuities."

Let's see…

    Stable investments. 

    Protection from losses. 

    Something that's not difficult to accomplish.

    Doesn't lock up money for years.

Cauldron 

If we stir the pot and put our minds to it, perhaps we can discover a way to accomplish those four goals.  I know it must be a very difficult problem because the top brains at banks, mutual funds, and financial firms everywhere cannot find an answer…

Eureka! It's not difficult at all.  Why can't these highly paid investment professionals see the attractiveness of creating a series of funds based on the conservative collar strategy?  Wow.  Can it really be as simple as that? 

Collars:

    Protect the value of an investors holdings by establishing an adjustable minimum value for a stock market portfolio.

    Cost very little (if any) cash out of pocket.

    Allow for limited growth when the markets move higher. 

Can it really be that easy?  Isn't owning insurance a far better method for protecting your assets than spending a lot of time on asset allocation and diversification? (These are not to be ignored, but they are far less important than you have been led to believe.)

Is there some obscure law that prevents the widespread use of collars?  Perhaps the problem is with me.   Perhaps I see a very simple solution to a very complex problem and there are obstacles that are beyond my understanding.  But I believe too many people have decided that options are not worth discussing and that's the 'end of story' (to quote Tony Soprano). 

To me, options are the perfect risk-reducing investment tool for solving this very important problem – how does the individual investor reduce the volatility of a portfolio and avoid those occasional financial disasters?  Not everyone is willing to place any limit of the amount they hope to earn by investing.  Such investors have to find their own solution for managing risk.  But surely investors who already have a nest egg that they cannot afford to lose will be interested.  Surely those who demand insurance against loss, but who are still accumulating the wealth would be interested. As would any conservative investor, regardless of age or net worth.

I wrote The Rookie's Guide to Options for individual investors who enjoy hands-on portfolio management.  No need to trust a broker or advisor to manage an account as a fiduciary should – with the best interests of the client being the only consideration.  Wall Street doesn't work that way – the broker comes first and the client comes next.  There's much to be said for doing it yourself.  For those who cannot manage their own finances, I'm out to get the financial planners and advisors of the world to join the 'options team.'  That will take some time.

Maybe it's the highly paid professionals who need this book the most:  The DWS team that tried to develop such a family of funds but failed to use options; financial planners who failed to protect the value of their client's assets; traditional stockbrokers who shun options.  These 'professionals' are amateurs to me.  I know that's harsh, but how can they be allowed to get away with ignoring the needs of the investing public?

Collars are not difficult to understand.  They are not difficult to employ.  They protect the value of an investment portfolio.  They allow room for profits to be earned.  Sure, they are not perfect because potential profit is limited.  But when the goal is protecting assets, especially among investors who want to keep what they already have, collars solve the problem.

With a family of funds, the investor can choose among actively managed funds and passive funds (mimic the performance of a broad based index).  There is no need to invest with 100% of your positions collared.  I recommend funds with 25%, 50%, 75%, and 100% protection.  Something for everyone.

Perhaps collars represent a solution that is just too simple.  Perhaps they are not sexy enough for mutual fund, life insurance, and bank executives.  After all, if it's as simple as I am suggesting, who would pay these people the enormous salaries and bonuses they earn?  I'd start my own managed mutual fund composed of collar strategies, but I'm a bit short on seed money.  Say a few billion dollars short.

Why are collars so effective?  As I described as a recent guest columnist for Steven Sear's column, The Striking Price, in Barron's, collars can be used by both active and passive investors.  Collars contain a built in insurance policy (buy put options) – and you choose your deductible.  Collars include an income stream (sell call options) that pays for the cost of the puts. 

The problem, or the sacrifice one makes when adopting a collar, is that profits cannot exceed a specified maximum.  That's true because you sell call options and those calls give someone else the right to take your stock by paying a previously agreed upon price (strike price).  Thus, if the underlying investment moves higher than that price, all profits above that price go to the call owner.

To me, this is an ideal situation.  You can use collars for any portion of your holdings, or for the entire portfolio.  That allows you to have as much protection as you feel you need, and enough upside potential to grow your net worth.

P.S. Collars are just to get investors started with options.  There are simpler strategies that provide exactly the same protection and returns as collars.  Options are truly flexible investment tools.

to be continued

388

5 Responses to Option Trading: How Important is Asset Allocation? Part II

  1. Erin 07/15/2009 at 1:35 PM #

    Hi Mark,
    Do you have an opinion on dynamically managed collars where one would typically roll up the put to lock in profits, perhaps roll up the call should the short strike be threatened, and purchase additional stock with the put proceeds should it move deep ITM?
    Thanks,
    Erin

  2. Mark Wolfinger 07/15/2009 at 2:21 PM #

    Erin,
    There is nothing special about the collar in that regard. Any trader can make a bullish or bearish trade when holding any position. Thus, no – I don’t have an opinion.
    But if you look at a collar as two trades: a covered call plus a long put, you can certainly adjust, roll, or do anything else to either position that suits you.
    I prefer to look at a collar as one of its equivalent positions: short a put spread or long a call spread (same strikes as the put spread). If you look at the position from that perspective you would probably have different ideas about when to ‘adjust’ or make a trade to alter the position. ‘Rolling up’ the call looks different when you are short a put spread.
    When the put moves ITM, you may have a profit on the put, but you still have a small loss on the overall position – so I would not consider using the ‘proceeds’ unless I wanted to reinvest more cash into this specific underlying.
    Don’t fool yourself into believing there’s any profit in this position when the put moves deep ITM. The put was purchased to prevent big losses, not to ‘make money.’

  3. rluser 07/15/2009 at 7:47 PM #

    I am in the choir and hear your preaching. Still the demon on my shoulder is reminding me of a single point of failure (at least for US equity options): the OCC. My entire portfolio remains undiversified if it is only backed by an OCC that fails. While I agree that the OCC through its members represents better diversification than, say, Lehman Brothers or AIG (or a very large number of other organizations), it is a reminder that options alone are insufficient for a well diversified portfolio.

  4. Mark Wolfinger 07/15/2009 at 8:38 PM #

    I don’t know what to say.
    I have not done due diligence, have done no research, yet I am taking it for granted that the OCC is invincible.
    You do raise an interesting point.

  5. Mark Wolfinger 07/16/2009 at 8:04 AM #

    Mr. User:
    I submitted your question to the OCC (Options Clearing Corporation) and received this reply:
    Hi Mark,
    While the reader sounds like a lot of the “doomsday” folks we speak with on a regular basis, he seems to contradict himself. He speaks about a ‘well diversified portfolio’ in the same sentence as ‘options alone’. That doesn’t make sense to me.
    We get these kinds of questions all the time: “What if New York, Chicago, Los Angeles, Buenos Aires, London, Paris, Frankfurt, Shanghai, Sydney, Tel Aviv, Toronto, Mexico City, and Tokyo all blow up at the same time?!
    And what if it’s on Expiration Friday and my index option is in-the-money by $0.01 — will I still get my $1.00??” All we can answer with is the ODD and the risks outlined therein — and also the industry’s highest rating that can be found here: http://www.optionsclearing.com/about/aaa_rating_08.pdf
    You might also suggest that some of these folks loosen the tin foil around their head……
    Regards,
    Joe