In the same way we buy insurance to protect ourselves and our loved ones, Options strategies can do the same for your portfolio.

In post #2 of this 3-part series on how to enhance a portfolio to insulate it against volatility, we focused on a relatively easy to implement strategy for the DIY investor. In our final post of the series, we will share with you a couple of the advanced methods utilized by some professional investors & managers. These volatility dampening strategies can help their clients to comfortably stay invested and achieve much (or all) of their annual investment goals, even through challenging markets.

But first…what’s an Option?

Essentially, an Option is a contract that gives you the right to buy or sell a financial product at an agreed upon price for a specific period of time.

How can Options both lower portfolio volatility & enhance performance?

Unlike a ‘low vol’ strategy, which focuses on a sector or certain investment type to constrain the outcome, some professional managers have the in-house expertise to choose whatever investments they thinks will do best at any given time. They can then write Options around these investments to reduce the volatility and generate regular monthly income for the portfolio at the same time.

For what types of investors is this sort of tool most beneficial?

As a firm that focuses on a very niche segment of the investment population, High Net-Worth, retired and approaching retirement age investors, ETF Capital Management clients are at the stage of their investment years where they have already ‘won the game’ and are no longer concerned with the market benchmarks. Instead, they are focused on their own personal annual benchmarks/goals that enable them to have a consistent lifestyle in retirement, from one year to the next.

Some Defensive Options Strategy Examples:

One of the most valuable Options strategies ETFCM utilizes for clients allows them to generate consistent monthly income while waiting to buy or sell a position at a more favourable level.

The implementation of this strategy involves:

1.Selling a Put option to buy a desired position at a more favourable entry price.

Example - Let’s pretend Tesla was trading at $100 and ETFCM wanted to buy in at $90.

  • If the position falls to or below this price they would gain the position and if it doesn’t, they don’t have to take exposure to the position above a level where they do not see good value in owning it.
  • In both potential outcomes, their clients get to keep the monthly premium income generated for selling the Put option.

2.Selling a Call option above their targeted exit point.

Example - Let’s pretend they now own Tesla at $90 and decide that if it moves back up to $100 they would look to crystalize their gains and exit the position

  • While this caps their upside at $10, this Option writing overlay effectively enhances the returns over and above the targeted amount of growth for the particular position - By generating those extra monthly premiums, they are able to add to that $10 gain without having to ride the position to an even higher and potentially riskier valuation.

A more complex utilization of Options strategy run by the ETFCM team enables their clients to both participate in a measured amount of market upside while at the same time, protecting against and potentially avoiding a sudden market downturn.

The implantation of this strategy involves:

1.Buying a Put to sell the position where the market currently is.

  • Their clients effectively make money when the market drops, and at the same time the client does not experience much (or any) of that initial downside.
  • The buying of a Put does cost money but they are able to offset that cost – see the next steps for how this works

2.Selling another Put where they feel comfortable taking back on the position - Say for example at          -15%.

  • Perhaps they like re-entering the position at a meaningfully lower valuation and by doing this they collect a premium that can be used to help cover the cost of buying that initial Put protection indicated in step 1).

3.Finally, they sell a Call option that caps the upside.

  • This allows for some reasonable participation in market growth and importantly generates monthly premiums which further help to cover the costs of paying for that downside Put protection.
  • For example, if 15% of protection cost $3, ETFCM works out how high to set the upside cap to make the $3 – for this example we will assume this is 12% above the current market price. The client is then protected from the first 15% of downside but if the market goes up more than 12%, they lose the additional upside over and above the Call price of 12%.

Compare this to a ‘low vol’ strategy that focuses on utilities, for example. This gets you a solid if uninspiring 6% but the ETFCM Options strategy could do 12% over multiple years.

Not for DIY investors

Picking stocks or selecting a one-ticket solution balanced fund is one thing but running Options strategies is a huge leap in sophistication level. It’s like going from a Honda Civic to an F1 race car; they both have four wheels and a steering wheel, but one moves a lot faster than the other and has a greater risk of injury.

But beyond the mechanics of the strategy and potential for greater returns than a basic low volatility approach, defensive Options strategies can provide the investor with a more controlled outcome even in the most volatile of markets. Instead of riding at the tops of the highs and being down near the lows of the lows, one would expect to see a more consistent year to year investment experience. A win or bust approach may be thrilling for sports fans but when it comes to retirement savings, why take any more risk than necessary to reach your financial goals. Keep calm and tame, not time, the market is the smart way to go.

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