31 Jan The Third Option
A Hedge of Roses
2018 began with a storm, as the major stock indices rose 4% in the first two weeks of the year, after a 20% increase in 2017.
One of my long-time clients, we’ll call him the “Hill-Boy”, always wants to know what I think.
I accept the challenge:
There is an enormous amount of money seeking returns, as conservative, low risk investments have lost relevancy because of low interest rates. Additionally, there is a constant flow of funds from active to passive management. Cultural changes, higher awareness of expenses, and above all a nine year bull market have created the sentiment that you do not really need to be a savvy investor; it’s enough to ride the index to new heights.
So here we are; valuations are high all around, and the inflow of funds into the market continues to drive prices higher and higher.
There are two options: to close your eyes and joint the party, or to take a more cautious approach. As expected, I choose the later.
Rapid technological changes, digital currencies and even the introduction of cannabis as a mainstream product for the average American in some states are some of the phenomena that have created a sense of bubble, raising questions as to how to properly price assets.
My answer is to hedge; on the one hand I am invested, and on the other- protected.
For this purpose, I use the most aggressive player in the capital market – but for defense purposes; I sell options against all equities in the portfolio.
Options are considered a sophisticated and aggressive investment tool, but when used for defense they can restrain the unruliness of the equity market. Research indicates that option sellers achieve higher returns than options buyers.
Defender Fund, our new hedge fund, is the third option; our equity portfolio is diversified and entirely hedged with protective calls. Option selling against a position limits our upside, while achieving downside protection.
By selling options against equities we own, we canachieve positive yield in a rising market, a flat market, or even a moderately declining market.
This strategy enables us to set a target yield, a tangible target yield based on premiums already collected – not expected appreciation. A hedged portfolio requires discipline and constant maintenance and is particularly well suited to wealth preservation.
When the entire portfolio is hedged with options, we have created a virtual hedge of roses to protect it.
A hedged portfolio serves investors well, as it enables to plan and remain calm even when markets shake. When the portfolio is hedged, the portfolio manager himself makes better decisions – and this I say from experience.
Dedicated to “Hill Boy”