All portfolio managers aim to
create and maintain portfolios that gain when market conditions are good and
lose little or no money when market conditions are bad. Yes, that sounds like
what every trader and investor would love, doesn’t it? Such portfolio or
positions are what professionals call “convex”. A convex position or portfolio
would have greater volatility to upside than downside and has been hailed as
the holy grail of portfolio designing. Convexity was once tough to achieve but
with recent derivatives innovations such as put options, convexity is not only
achievable but easily performed even by amateur investors.
There are three levels of risk in
the capital markets; Systematic, Secondary, Idiosyncratic.
Idiosyncratic risk is risk to
your portfolio when a single company stock fails. Secondary risk is risk to
your portfolio when an industry as a whole fails. Systematic risk is risk to
your portfolio when the overall market fails.
If you have a diversified
portfolio of stocks, you should be able to minimize the effects of
idiosyncratic risk or secondary risk as holding different stocks across
multiple sectors protect your portfolio in the case when a single company or
industry fails. However, there is one risk that can never be diversified away
and that is systematic risk. Yes, despite what anyone tell you, systematic risk
cannot be diversified away no matter how diversified a portfolio is. That is
why your portfolio value will decline dramatically in a market crash no matter
how diversified it is. Truly, there is almost no way to produce convexity in a
stock portfolio under every condition without the help of insurance derivatives
such as put options.
What are put options?
Put options are derivatives that
gives you the right, but not the obligation, to sell the underlying stock at a
fixed price. Yes, put options act like insurances! For just a small fee (known
as the option premium), you can buy protection for your stock portfolio to
prevent it from ever dropping in value! Yes, convexity at its best!
Lets take a single stock for
instance. Assuming you bought 100 shares of ABC stock at $50 per share. At this
point of time, this is a position without any convexity. This means that the
value of the position can fall all the way to zero and it can rise as much as
it can fall. Now, assuming you bought 1 contract of put options covering that
100 shares of ABC stock at $50, you would have incurred a small “insurance fee”
but would have prevented the value of your position on ABC against any drops at
all! A position that cannot lose money! Yes, that’s a convex position! If ABC
stock continues to rise, the put options simply expire on its own when time is
up and you would not have to spend a cent more on those put options. Just like
insurance.
Now, if you have a totally
diversified portfolio covering almost all of the 30 Dow component stocks, all
you have to do is to buy put options on the DIA, which is the ETF for the Dow
Jones Industrial Average, in order to protect your entire stock portfolio
against a decline in value!
Even though you pay a fee for
those put options, it is a very small fee compared to what you can lose if the
stock should fall in a crash and would certainly help you sleep better every
night.
Yes, convexity can be introduced
into any stock portfolio simply by buying put options as protection for your
portfolio. Learn more about put options at http://www.optiontradingpedia.com/put_options.htm
.
