Market upheaval can be gut wrenching. The market can experience 5% and 10% declines with surprising frequency, with a typical bounce back relatively quickly. But once in a while you get a 2008 event where the market just continues to go down. Unfortunately, there is no way to identify which of those two market conditions an investor is in until after the fact.
These conflicting emotions certainly play into the documented reality that investors tend to exit markets at the wrong time – selling when they should be buying and vice versa.
Fortunately, there are solutions. A tangible floor on losses can go a long way to mitigating these realities – allowing for investor participation in the market with a safety net below.
How can one create an investment floor? Most products experience a constant level of exposure, leading to the conundrums we just described whereby the investor has no certainty as to the direction or the magnitude of market swings. Option driven strategies are different; they introduce the ability to shape an exposure – for instance, depending on his or her needs, an investor can choose to have anywhere from 0% to 100% exposure to a given security within a given range of outcomes. A long call, for example, provides upside opportunity above the call level but no exposure below.
Purchasing put options provides a reliable insurance policy against market downturns by inserting a floor to your downside exposure. Marrying this “insurance benefit” with a long market exposure allows an investor to participate in up markets while protecting him/herself from downside risk.
In volatile markets like this one, it is appealing for investors to have a tangible investment floor. By taking tail risk off the table, investors can have a better understanding of their true risk and thereby a better ability to navigate volatility. While options can help make this a reality, note the use of options as insurance does cost time, complexity, and money – thus, the best way to take advantage of these strategies is often through a fund or other packaged solution.
Exceed investments is an asset manager specializing in defined outcome investing, which uses options to shape market exposures. For further information visit our website.