Protect and Participate

Vol #26- February 19th, 2021

It took me a long time to understand what was meant by the phrase “have your cake and eat it too.” While the overall meaning was clear - you wanted the best of both worlds - I never quite understood what the point of having cake was other than to eat it. (Besides, I’m much more of a pie guy anyway.)

When comparing investment opportunities, we’re presented with the same dichotomy. We all want to reap the benefits of rising asset prices, but don’t want the pain of a drawdown. As human beings we’re very prone to anchoring ourselves to the highest account value, and any number below that brings on the visceral feeling of losses.

Armchair and professional investors alike are constantly looking for ways to divine where the markets are going. As asset prices from stocks to Bitcoin continue to float up, the nagging question grows louder - if I could just sell in advance of the drawdown, I’d be able to eat my cake now, and then buy more cake for a lower price next month.

Managing this exposure is what brings many people to options strategies. Maybe there’s a way to earn the gains without the pain. A way to both protect and participate.

There’s no such thing as a free lunch, so cost is a major factor to consider. With regular insurance, you’re simply offered a quote in dollars. With one million different strike listings in the equity options space, there are a variety of ways to pay for protection. Options positions exchange varying degrees of upside participation and tailor the precise level of offset on the downside.

This customized exposure should align with individual preferences and inclinations. We’ve talked before about how other’s objectives are not yours, and that the risk and strategy of each investor should match their needs. Once you’ve identified your objectives, systematic implementation is what keeps your portfolio balanced through different market cycles.

A simple exercise to think about your desire to protect and participate is to use the zero cost collar. A collar position consists of buying a put and selling a call, typically for “zero cost”. This zero cost strategy can be done at nearly any level.

Do you want a tight collar where you’re buffered against moves of more than 1% in either direction? Or are you willing to accept a 10% drawdown in exchange for the possibility of a 10% rise?

As tail risk strategies become more complex, they involve different ratios of options and exposures across different terms. A rolling slingshot is a great way to finance protection incrementally. When you need your investments, and how much you’ll need will dictate the various constructions.

While you might not be able to truly have your cake and eat it too, derivatives can keep your portfolio on a steady diet that meets the objectives of both your sweet tooth and your waistline.

Thanks for joining us,

Mark Phillips
CEO

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