Enjoying the thrill of investing without the dangers: Controlling your Risk / Reward Exposure

The Kingda Ka roller coaster is one of the largest and perhaps scariest roller coasters in the world. After a fear invoking pause, it launches out of the gate, achieving a speed of 128 miles an hour in 3.5 seconds. It then goes 456 feet in the air before plummeting back down. Sounds like great fun for screaming teenagers (Alas, I’m past the age of appreciating the ride).

Airplane rides through turbulence also tend to shoot up and down, but they don’t seem to capture this same delight – more often than not, passengers are frequently annoyed and genuinely terrified.

One critical difference between a roller coaster and an airplane is how controlled the environment is. A roller coaster is a thrilling but controlled experience – as scary as it may seem, people know exactly where it starts and ends. In between those, riders get to shoot up and down and flip around in a safe environment.

An airplane ride is not a controlled environment. Turbulence is unpredictable and often uncontrollable, and there is always the small but real risk that the pilot really does lose control of the situation.

While financial markets are often described as a roller coaster, the better analogy is the airplane ride. There are no rules that dictate where the market can end up at any moment, as periods like 2008 have demonstrated. And the uncertainty of those outcomes can play havoc with people’s lives and livelihoods.

A number of financial products attempt to smooth out the ride and provide a level of control to equity investing – e.g., low volatility. However, these solutions tend to mitigate rather than eliminate the exposure. For instance, there is no limit to what losses can be borne within low volatility strategies – there is simply the assumption these losses will be lower than the overall market. Truly controlled environments are essentially unattainable through most conventional equity solutions.

It is only through options and products utilizing options, such as structured notes, that a defined level of control can be achieved within equity investments. Let’s do some technical analysis to see how we can move investors from the airplane to the roller coaster.

Options are contracts that allow the holder (buyer) to go long or short an underlying security at a defined level. For example, if an investor owns the S&P 500, which is trading at 2000, and wants to protect from losses of more than 10% over the next 12 months, the investor can simply purchase a 12 month 1800 strike put (2000 * (100% – 10%)). If the S&P finishes below 2000 but above 1800 (i.e., less than a 10% drop) in 12 months, the put expires worthless and the investor is out the loss in the S&P. If the S&P finishes below 1800, than the put has value at maturity equal to the lost amount below 1800, so the investor cannot lose more than 200/2000 = 10%. Voila! The airplane has become a roller coaster.

Protective Put

Unfortunately, putting on this defined level of protection can be difficult for a layman. Some reasons include:

• Complexity: working with options can be a difficult exercise for the uninitiated
• Strike price: Most options trade at standardized strike prices, which may not provide the precise protection levels sought
• Time period: Options are term dated products with market driven start and end points. Investors need to figure out the period for which protection is warranted and then need to find the closest market dates that work

There is another strategic barrier as well – Cost. Options cost money (I know, shocking). On a percentage basis, the cost can be meaningful.

The combination of complexity, strike difficulty, term nature, and costs results in it being a not simple task to consistently protect a portfolio.

Let’s talk about some solutions:

Option spreads: One way to solve the cost issue is to package a purchased option with some sale of option in order to negate the upfront cost of protection. Option strategies such as a zero cost collar, where the investor gives up some of the upside to get some protection on the downside, can work here. Many structured notes shape the risk / return payoff to sacrifice return in order to mitigate risk – for example, a two year 10% buffered note with a 20% cap would protect on first losses on the S&P while participating on price gains up to a 20% cap. [Note that options and structured notes do not pay out dividends on the underlier.]

Buffered Note

Outsourcing: The complexity, strike price, and term nature of options are best addressed through experience and expertise – while some users can do this themselves, others may find it more efficient to outsource this through purchase of products such as structured notes and mutual funds which provide these strategies. There is also a complexity of applying options and structured notes across multiple accounts due to its lack of standardization and term nature. Some outsourced solutions include:

• Structured notes are the most defined and straightforward, as they are obligations of the issuing bank to deliver some predefined return. However, as IOUs of the bank they are illiquid and carry concentrated credit risk. In addition, they tend to be high fee
• Various mutual funds and ETFs offer option related strategies; while lacking the precision of a structured note and adding cost to the DIY path, these vehicles provide a middle of the road solution that provides a controlled environment without the major drawbacks of the other solutions. Recently, the CBOE reported a definitive list of options-related funds available in the market today. Our feeling is that this list will continue to grow.
• Separately managed accounts provide a more tailored fund-like experience for larger investors; these solutions can be customized to individual needs such as desired market exposure
• Hedge funds provide substantial options expertise and outperformance opportunity, often at the expense of high fees, illiquidity, and non-transparency

Effectively using option strategies can be complex, and is often best outsourced for all but the most experienced investors. There are a number of outsourced solutions, with new and innovative strategies coming out all the time. However, there is no “perfect” outsourced solution, so selecting the right one is as much about the investor’s needs and outlooks as it is about the solution.

In conclusion, options and strategies utilizing options can provide significant control over the investment experience. This control can be paid for directly or through “soft dollars” by simply exchanging upside gain to protect from downside loss. By going the “soft dollar” route, the investor is simply reshaping their risk/reward exposure to one which better matches their objective.

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