As the markets head higher, I watch in amazement. The S&P 500 Index is marching steadily towards 1200, the DJIA has passed 11,000 and all is right with the world. And that's one reason why I am not a market prognosticator. This rise is completely unexpected by me.
I note that companies are making money through higher productivity, and assume they are in no hurry to add employees when they can function efficiently with so few. However, I wonder who is going to be buying their products when so many are unemployed, and so many others have become much more conservative in their spending habits.
I shrug my shoulders and accept the fact that I cannot predict market direction. However, I'm wondering how individual investors – those who are not optimistically bullish – are handling this market. I know those who are fully invested are happy campers. But are they worried?
My belief is that this is an opportune time to consider using options as a tool for reducing the risk of investing. I would never tell any investor that hedging is necessary. My objective is to be certain investors understand that it's possible to hedge their holdings with options, show then how to do it, and allow them to make the final decision.
Something for nothing
I've spoken with friends who are long, and love being long. Two have investment accounts that return 7.5 and 12% respectively. These are not capital gains. These are dividends and interest payments. Not wanting to tell someone else what to do, especially when they are making money and are happy, I did ask: Aren't you surprised to be able to earn such high returns when banks and Treasury Bonds return so little? Aren't you concerned that these high returns are accompanied by higher than normal risk? Don't you ask yourselves: Who would pay 12% interest when most people would be thrilled to earn half that amount in interest?
Neither friend is concerned. One trusts her broker (not her advisor, but her broker, who is nothing more than a salesman) to take good care of her, and the other is overwhelmingly diversified, with far too many ETFs in his portfolio. Neiher sees a problem with earning such high returns. They see no risk – other than market risk.
Who needs options
To me these are the investors who should consider some from of portfolio insurance using options. It should be standard fare as intelligent risk management. Whether it's the purchase of OTM put options, buying collars on specific holdings, or selling a portion of the portfolio and holding more cash, it's prudent to pay attention to risk and not to pretend that markets will rise forever. And if they do rise forever, earning less money by owning insurance is not the worst result in the world.
Investors who own home insurance, car insurance, life insurance, and insurance on other costly possessions never consider insuring their investment portfolios. I cannot understand why this is true – other than the fact that the brokerage industry makes no attempt to alert their clients to the availability of such insurance.
I'm not suggesting that owning insurance is mandatory, but I do state that ignoring the problem and not thinking about what can be done to protect one's holdings, is a big mistake.
That's one reason why I believe options education is a good idea for the vast majority of people who have nest eggs worth protecting. They may decide options are not what's needed, and I would never argue with that decision. However, remaining ignorant about how options work and not bothering to learn that they are risk-reducing investment tools, makes no sense to me.
One big problem is that those who do seek information, often find it in the worst possible places and pay exhorbitant prices to learn something about options. Instead of heading over to one of the option exchanges, the OIC, their broker, or a trustworthy source, investors succumb to temptations offered in TV infomercials, advertisements for weekend seminars or introductory option classes that cost as much as $10,000.
That's far to much to spend. An options education requires an understanding of the subject and cannot be crammed into the head of a novice over a short time span. One must be very familiar with a topic before being bombarded with information that requires time to digest. Graduate students can receive such detailed information in seminars, but it's inappropriate for freshman courses.
To me that's a shame that too few brokers and financial advisors suggest portfolio protection. Investors are once again being set up for getting hurt- the next time the bear returns to dominate the market. And that may be soon, or not for for years.
The tragedy is that it's all so preventable, and at a reasonable cost. I believe options should be used as hedging tools by far more individual investors, but reaching that audience has been a near impossibility