Posted on 19 March, 2011 | 75 Comments
As an options trader and as a specialist in risk management, I often get annoyed when I read about risk mitigation strategies in any number of business newspapers and magazines. Rare is the case where I read an insightful article on the use of options strategies, particularly the protective put, to manage volatility within one’s portfolio.
All too often, authors focus on asset allocation as the primary mechanism for managing risk. In order to preserve capital, low risk investors should overweight fixed income products like GICs, government bonds, investment grade bonds, and underweight equities.
To further this argument, authors often display historical chart information to graphically illustrate the steadiness and consistent returns from bonds over the last twenty, even thirty years.
Problems With Relying On Asset Allocation
There are a number of problems I have in relying on asset allocation as a risk mitigation tool. First, only two years ago, we laid witness to the fact that all asset classes were hit hard. It did not matter if you held investment grade bonds, junk bonds, small cap stocks, preferred shares, or blue chip stocks in your portfolio, everything took a beating. Asset allocation did not turn out to be the safe haven that many thought and counted on.
Is Fixed Income Really A Safer Haven?
The second issue that I find bothersome is the assumption that fixed income is a steady eddy asset class over the long run. Many investors are oblivious to the fact that we have been in a declining interest rate environment for the last thirty years. Interest rates have dropped from twenty percent to one or two percent. So is it any wonder that bonds have done so well – it is simply a function of falling interest rates — as interest rates go down, bond prices go up.
On that note, one has to question a historical bond chart, even one with thirty years of history, if it is statistically representative.
Now that interest rates are slowly creeping up from their all-time lows, it could get very ugly, very quickly for bond holders. Unfortunately, I foresee a lot of seniors taking it on the chin once this bond bear market kicks in — especially those seniors being advised by their bank mutual fund salesperson to buy into bond mutual funds.
Capital Preservation At The Risk of Inflation
Finally, the third issue I have with the ‘bond safe haven’ argument is that few advisors make mention of the risk of inflation. And in today’s high commodity price environment, I fear too many investors are exposed to inflation risk – specifically the loss of purchasing power.
It does an investor little good to earn 3 percent on a long term government bond if inflation is running at 4 percent. True, the investor is almost certain to see his initial cash outlay returned as the bond matures, but the investor will have lost in real purchasing power. Unfortunately, too many investors associate capital preservation with the likelihood that cash is returned all the while ignoring the risk of inflation.
Problem With Laddered Bond Strategies:
That brings us to the next type of business news article which discusses the benefits of a laddered bond strategy. In a laddered bond strategy, an investor owns a number of different bonds, each with various maturities. Some bonds mature earlier and some mature later. Presumably, if interest rates rise, the bonds that mature earlier can be re-invested in potentially higher yielding bonds. Thus the exposure to inflation and higher interest rates is diminished.
On paper, the strategy sounds great. One problem though: in this low interest rate environment, the returns from this strategy are lousy.
The Protective Put
All of which brings me to the protective put strategy.
The concept of an index put is very simple. It is very much like insurance with the added benefit that it trades on an exchange. Unlike ‘asset allocation’ which did little to shelter portfolios against an outright collapse in the financial markets, puts most certainly protect investors against extreme market events.
Furthermore, puts give conservative investors much more leeway in bumping up the equity portion of their portfolios. Generally, it would be unheard of for a conservative investor to assign more than 65% of his portfolio towards equities. But with put protection in place, an investor has the flexibility to increase the equity portion towards even 80% with the knowledge that an effective hedge is in place should the market collapse.
Puts: The Concept Of Insurance
As mentioned, puts are equivalent to insurance. Like insurance, there is a cost to a put. A buyer of a put pays cash to the seller in what is known as the option premium. What is kind of neat is that the put premium is liquid and trades on an exchange. Investors can buy and sell put premiums exactly in the same manner that they buy stocks (eg. enter a ticker symbol, enter a price, and click ‘buy’ or ‘sell’)
Like many types of insurance, there is an expiration date associated with a put. After the expiration date, the put no longer trades and is considered terminated.
Put premiums appreciate in value when the market drops and decrease when the market goes up. But, put premiums cannot go below zero. Upon expiration, the put will be “in-the-money” and have monetary value, or it will be worthless. Keep in mind, that the maximum amount that a buyer can lose is the put premium. The buyer cannot lose more than what he paid for the premium.
One More Feature: The Strike Price
In addition to an expiration date, puts are described by a strike price. The strike price enables investors to further customize the level of protection.
For example, if the TSX is trading at 14,000, an investor may choose a put with a strike price of 14,000. That particular put protects the investors against a market drop below 14,000. Another investor, however, may choose to insure his equity portfolio at a lower strike price, say 13,000. Here, the investor has protection but only if the index falls below 13,000.
Why would an investor choose a strike price of 13,000 versus 14,000, one might ask? The answer is cost. A put with a lower strike price costs less than one with a higher strike.
Having the ability to buy insurance at various strike prices gives investors a tremendous amount of flexibility in tailoring a risk strategy. Some investors may be fine with a marginal drop in the market but want protection to kick in only in the event of a catastrophic event. Those investors are more likely to choose a strike price below current market levels – say 13,000. Other investors may want a higher amount of protection and choose a higher strike price that is more in line with the current market – say 14,000.
Volatility and Put Premiums
While both expiration dates and strike prices affect put premiums, volatility is the most important factor in determining relative value. This is why many option traders track a volatility index called the VIX in order to assess the relative value of options.
When volatility is low, option traders know the cost of the put premium is relatively cheap. Likewise, the reverse is true. If volatility is high, put premiums become relatively more expensive.
Intuitively, this makes sense. Investors are more fearful in highly volatile markets and are therefore willing to pay more for insurance in order to protect their portfolios.
With investor sentiment bullish and the VIX trading at near lows in Jan & Feb 2011, Frontwater loaded up on 2012 protective put options on the TSX, DJIA, and S&P 500. This week we were rewarded. As stocks dropped, the index puts that we bought increased in value and our portfolios only suffered marginal paper losses. With insurance in place, not only were we able to avoid knee jerk reactions but we were positioned to take advantage of the first weekly drop in several months and added to our equity positions at depressed levels.
Admittedly, we bought the puts from a purely risk management perspective and not because we had a crystal ball that could possibly forecast the political unrest that would break out in the Middle East or that a terrible natural disaster would hit Japan.
That said, we complement ourselves for recognizing the most cost efficient way of managing risk at the time was through the use of put options. The protective puts offered great value, enabled us to comfortably maintain a higher level of equity allocation (close to 80%), and then positioned us to further take advantage of a market drop.
Option strategies can be a powerful risk management tool within one’s portfolio. All too often they get dismissed as being ‘too sophisticated’ for the average investor which draws my ire. True there are many complex option strategies but buying a put is a very simple investment strategy and insurance policy at the same time.
Jeff Kaminker
President, Frontwater Capital
June 28th, 2012 at 11:03 am
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