Objectives and Benefits
An allocation to options can provide benefits and accomplish very specific objectives for the risk and return characteristics of investment portfolios.
Options investments can be structured to reduce or eliminate exposure to investment losses during negative market periods. Options investments can at the same time be structured to permit exposure to specific amounts of gain during positive market periods.
The overall objective is to enhance the probability of gaining a targeted return that will fall within a specified range over specific time periods during future positive and negative market periods.
Options can be added to a portfolio to meet an individual’s desire to eliminate the portfolio’s exposure to various amounts of market losses. This is accomplish through the purchases and sales of “call” and “put” options that will offset a specific amount of market losses over specific time periods in exchange for accepting a specific maximum ceiling or “cap” level for market gains over the same time periods.
An Options Allocation Example that Reduces Market Decline Risk
Numerous hypothetical examples for different market scenarios can be illustrated. This hypothetical example shows a grey colored line representing stock market prices over the period. The blue line represents prices over the same period assuming a specific options allocation has been included.
In this example it is assumed that a “bear” market decline (more than 20%) is experienced. The last time this happened was during the “great recession” 2008-2009 market decline. Over the past century such declines have occurred 32 times averaging once every 3.5 years. Over the time period, the hypothetical stock market return is shown declining by 25%.
Over the same period the addition of an options allocation can be constructed to eliminate an investor’s exposure to a specific amount of stock market decline. In this case, market losses up to 15% (shown here as the “buffer level”) will be prevented. Had the market ended with the market downturn remaining down 25% at the end of the options expiration period, the investors loss would have been reduced to 10% (25%-15%).
Adding an options allocation also continues to permit participation in stock market gains up to a specifically constructed limit (in this case 22.24% shown as the “upside cap”). The illustrated period shows the stock market recovering all its losses and continuing to make gains that closely match the stock market’s gain at the end of the period.
Because the underlying options contracts had little time value remaining, and the stock market’s gain was below the upside cap, the investor’s value remained near the cap even while the market experienced more volatility.
On the last day of the period, the investor’s gained equaled the 22.24% upside cap, nearly matching the market’s gain over the same period.
In summary, what has been accomplished here is a good result for the investor in accomplishing participation in potential market gains, while at the same time reducing the risk of participating in potential market losses.
Greg Tinaglia
Last Updated: 07/11/2019