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Submitted by Zega Financial on January 23rd, 2015

By Derek Moore

Most people when thinking about options describe them as adding risk to a portfolio. Options have leverage and when used improperly do add risk to a portfolio. Yet, many of your clients probably remember 2008 where the markets at one point were down around 50% before recovering to close the year down 37%.

So how can using leverage with options reduce risk? We have to think in terms of creating notional exposure to a broad market while at the same time reducing our max loss to a fixed amount.

As of this writing, the S&P 500 Index is currently sitting at 2054.38. Someone who wanted to own large cap S&P might purchase the SPY ETF or some other mutual fund that mimics the index. If another 2008 scenario happened and the assets werent hedged, they would bear losses along with the market.

Notional value is the value which an investor controls of the market they are looking to invest in. But instead of buying shares, they are controlling the same amount but through options.

Consider that buying 1 S&P 500 Index At-The-Money Call expiring January of 2016 would control $205,438 of the S&P 500 Index. Because of leverage, 1 contract is equal to a notional exposure much higher, yet the initial and at risk capital to put on the position is much less.

The January 2016 long term S&P 500 Index Call option is currently trading at $123.00. Since an options contract represents 100 shares the multiplier 100 X $123 means that the investment would equal $12,300.

Now, think about an initial investment of $12,300 versus $205,438. Heres where it gets interesting. The cost of the option is about 6% of $205,438 and only the initial $12,300 is at risk. Thinking about it another way, a client with this position on would only lose 6% of their $205,438 if the market went down 50% instead of $102,719. Below well explore some scenarios at expiration with the S&P 500 down and up.

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Youll notice that when brought to expiration, there is significantly less downside risk using options to create the same notional value as if the SPY etf was purchased. The max drawdown on the Jan Call Option was 6% versus 100% theoretically at risk owning shares. The reason why the SPY gained more than the option was that the SPY gains from dollar one while the options has to overcome its initial cost or premium.

You probably remember that since we were only using 6% of the cash, the rest of the money could be invested in a hedged fixed income strategy to generate additional returns through regular dividends.

Whether it be the Buy and Hedge retirement strategy using options to create notional value or the Buy and Hedge Classic hedged equity strategy, you can help protect your clients against years like 2008 while still participating in up moves in the market.