Option Trading: Is Asset Allocation Still Important? Series Finale

MachineGhost left a comment regarding this series on the importance (or non-importance) of asset allocation:

"Good stuff. But to complete the series, how about giving various
examples of how "easy" it is to actually hedge a stock portfolio
effectively, as well as the various pitfalls to watch out for."

A reasonable request.  Not so easy to fulfill.

As a reminder, the underlying suggestion in this series is that 2008 was a devastating year for most stock market investors.  Asset allocation, along with diversification, may have failed some investors as a risk-reducing method during the market decline.  To the extent that such investors are seeking alternative methods to protect the value of their portfolios, I recommended adopting the collar strategy – but only after taking the time to understand how that strategy works.

For those who don't rely on the standard 'prudent investor' rules – in other words, for investors who either never believed, or now believe, that yesterday's rules are no longer sufficiently reliable to provide protection for their investment portfolios, collars can be used to guarantee that the value of a stock market investment never falls below a specified value. 

Collars are not insurance policies per se, but they resemble insurance policies sufficiently to describe them in those terms.  For review, look at the graph that compares the performance of SPX (long, unhedged investment in the S&P 500 index), BXM (same, hedged by writing covered calls), and CLL (same as BXM with the purchase of put options).

Collars reduce returns in bull markets and cut losses in bear markets.

***

1) The only way to hedge a portfolio 'completely' is to own a collar position for each 100 shares of stock in your portfolio.  If you have a diversified portfolio, or if you own odd lots, this is not an efficient method.

2) If you are a passive investor and only own shares of exchange traded funds – SPY (S&P 500) would be the one most commonly owned – you can easily collar that investment.

3) To provide reasonably 'effective' protection you can compare your holdings to certain indexes – selecting the index that most closely resembles your portfolio, and then collar that index.  This is 'doing the best you can,' and for many, that's not good enough.  It introduces the risk that your portfolio may perform very differently from the index that you collared.  This is a real risk, and could provide extra profits or losses.

Example, if you own tech stocks, you may find NDX (choose the ETF QQQQ) to be a reasonable choice.  If you own a diversified portfolio of large industrial companies, then SPX (choose SPY) is the index to follow.  Your portfolio may look more like a mid-cap index (MID, MDY) or a small cap index (RUT, IWM).

Once you choose your individual 'benchmark' index, you must decide how many puts to buy and calls to sell.

Let's take an example:  SPY is trading near $88 per share.  Take the value of your portfolio and divide by $8,800.  That tells you how many SPY options you need to build a collar.

Keep in mind that SPX ($872 per share) also has options, and if your portfolio is worth at least $87,000 you can buy one SPX put and sell one SPX call to approximate your portfolio.  For in-between portfolio values, buy some SPX collars and some SPY collars.  This works best with a low-priced broker.

Problems and thus, questions about effectiveness:

a) How well does the performance of your portfolio correlate with that of the benchmark index?  If you have not held this portfolio for a significant period of time, you will not have enough data to really know he answer.

b) When you collar an index that you do not actually own, your broker is going to look at the position as a naked call option.  Some brokers do not allow you make that trade.  If you have a broker who is less restrictive, the margin requirement (these vary, so ask your broker) for that naked call may impose a burden on your account.   You never want to have a margin call.  Do not fool around with these naked collars if your account is in danger of receiving such a call.

c) If you regularly trade in and out of positions, then part of the time you will be over- or under-hedged.

How effective is this:  Much better than no hedge, but there is that correlation risk to consider.


Strike prices:

That's a lengthy discussion in its own right, but it's similar to choosing a deductible when you buy insurance.  You can buy puts with a strike of 86 or 87 and get pretty good protection for your SPY position.  Those puts cost more than lower strike puts – but the question for you is: how much are you willing to pay for insurance? I cannot answer that for you.  I make this suggestion:  No matter how experienced you are, if you never previously considered trading this strategy, do so in a paper trading account.  That will give you a feel for how this works with a real position. And you may decide it's not for you.  Or you may decide to protect only half (or some other fraction) of your portfolio.  This is a very flexible strategy.

When you choose the calls to sell, there are two major considerations:

a) Do you want to collect as much, more, or nearly as much, premium as you paid for the puts?

b) Would you prefer to sell a call with a higher strike price?  That allows for higher profits in a rising market, but it also means that you will be paying cash for the collar position.  That often results in a small loss, even when the market moves a bit higher.

Bottom line: If you adopt collars as insurance, you don't have to depend on asset allocation and diversification as your primary risk-reducing investment methods.  But, please don't conclude that you need no protection.  And this strategy is not for everyone.  If you are bullish and want to play for a rising market, this strategy will severely hinder your performance, unless you buy cheap puts for just a bit of protection and sell calls that are far enough OTM to provide the chance for a good upside.

This strategy is worth understanding, but it is not a recommended trading idea for most readers.  It's for the conservative investor who is willing to accept limited growth in exchange for a guarantee than he/she will not be hurt if there is a market debacle.

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