Protecting a Stock Market Portfolio with Collars. Which Options to Trade?

This ongoing conversation has points of interest for readers who are not yet experienced option traders.

I hope to convince those option newcomers that options are the most versatile investment tool around.  More than that, they can be used to guarantee a floor on the value of your investment portfolio.  That's something that no advisor who advocates that you trust the combination of diversification and asset allocation can promise.

Those methods provide some protection, but they offer no guarantee.  Insuring your portfolio with options does.

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The comment/question from AZ has been abbreviated.  Click to read the entire comment

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Mark,

Thanks for all your help…  I have a few points of clarification [MDW: Replies in tomorrow's post]

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Hi ZA,

I believe that taking the time to respond to your detailed questions helps others as well and provides a topic for discussion.   In addition, this gives me the opportunity to expand on my general investment philosophy.  That includes pleading with the investing public to understand the risk of investing when unhedged, and the value of learning how to use options to protect a stock market portfolio.

So many financial planners ignore the needs of their clients by using dated risk management techniques.  When I post on their blogs, offering my point of view, they scoff and otherwise belittle anything new.  They claim to understand options – and some do – but they would rather gamble with their clients money than use options.

I'll go out on a limb and claim to know their rationale for not using options:  By sticking with the old 'tried and true' they can absolve themselves of any blame (and still collect a nice management fee) for the lost money.  But, if they think for themselves, and earn less than others on a big rally, or lose the predetermined maximum in a market crash, they risk being sued by ignorant clients who claim that 'trading options' was the blame for their not achieving expected returns.  The financial planner would be sued for using 'risky' options.  Rather than take that personal risk, they ignore options – to the detriment of their clients.  That's when they ought to be sued for failure to do what's best for clients.

If anyone still believes that asset allocation, by itself, takes care of the problem, then that person is living on another planet.  Sure, gold and stocks often move in opposite directions.  Yes, bonds and stocks can do the same.  But for many years, stocks and bonds moved in tandem.   In today's globalized world, assets are much more likely to move together than they were decades ago. That means less hedging.

Asset allocation works when you own the RIGHT assets at the right time.  There is just too much luck in that approach.  I believe that investors – who want to protect their assets – ought to have a portion (even all of it) invested in collars.  The portion of assets so invested can be 100% or as little as 20%.

These concepts are not just for planners.  Any individual investor who is concerned about the value of a portfolio can adopt the collar strategy.  I recognize that my readers trade options, but I am always hoping that people searching for portfolio safety will find their way to Options for Rookies and take advantage of the information that's available on this blog.

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ZA,  What I don't know is whether you are confused because there are too many variables for you to see the big picture, or whether you are truly new at options and have been moving too quickly.  There is no point trying to grasp the finer points when you are still studying the basics.

If you are truly new to the options game then not much of this is going to be clearly understood until you slow down and get a solid background first (Rookie's Guide).

To be continued…

707


Lessons of a Lifetime: My 33 Years as an Options Trader


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2 Responses to Protecting a Stock Market Portfolio with Collars. Which Options to Trade?

  1. ZA 06/03/2010 at 12:25 PM #

    I want to once again thank you for your help with all of this. It has been extremely helpful.
    I agree with much of what you said on asset allocation, which why I have been active on the message boards. In my opinion, it can not be and end all be all to risk management and as such the use of insurance (in our case through index collars) should at the very least be an option (no pun) to clients, assuming they can grasp and understand the risk/reward tradeoff.
    Furthermore, your observations point the fact that beta may not work as a gauge to determine how the strategy should be implemented; however, if we are using an overlay options strategy to hedge our diversified portfolio I can’t think of a better way. Plus, as you mentioned, some protection is better than none.
    I am relatively new to options and have been researching various strategies for about 2 months. Again, the main goal of utilizing options would be for insurance and income purposes. I have read various books, passed the Series 4, and have read all entries from your blog that I feel would be relevant to what we do, among other aspects of self study. From that research I have even developed a broad outline on how we could implement the various strategies. I hope to use this outline to ultimately guide our trading strategies, but realize I need to make sure I have done enough research to make the trades work as anticipated (in a relative sense) for the client.
    Lastly, the reasons for my questions is that I am just as concerned about improperly implementing an options trade as I am about not allowing them the opportunity to insure at least insure part of their portfolio. I think this is something we would both agree on. As such, I am trying to dig up as much information as I can so I can feel comfortable and know the risks of trading options.
    I hope that helps clarify where I am coming from and how I wish to advise our firm’s clients. I look extremely forward to hearing your response tomorrow and plan on purchasing your book sometime this week. I am truly appreciative of your guidance.

  2. Mark Wolfinger 06/03/2010 at 8:40 PM #

    ZA,
    Glad you want to take care of your clients. These days integrity is in short supply.
    As a newcomer to options, you are seeking to get into some more detailed discussions, and that’s fine. You are asking good questions. I believe you will have a better understanding when you get more of the basic stuff behind you.
    The RGTO will be helpful. Readers tell me they are glad they found it.