Despite the strong start for markets in January 2023 this still has the potential to be a challenging year. A cautious approach with the portfolios is likely warranted.
We have mentioned several times over the years that we use options to reduce the volatility of portfolios, but what does that mean? Here is a simple example that might help.
We own Apple stock in one of our pools. Markets were strong in January and at one point Apple was already up about 14% in 2023. However, the outlook for markets in the coming months was questionable. We believed Apple was a great company that we still wanted to own in the portfolio, but we didn’t want to lose all the gains if markets fell back down again.
We added an option collar for the Apple stock we owned in the pool. This helps in several ways:
1. Limits downside risk: The primary goal is to limit the downside risk of the stock. It involves buying a put option to protect against a decline in the stock's price while simultaneously selling an off-setting call option to generate income. This strategy effectively limits the loss an investor may incur if the stock price declines - for close to a zero cost.
2. Provides flexibility: The option collar provides flexibility for investors who may want to hold onto an asset for the long-term while still protecting their downside risk. This strategy can help investors avoid the need to sell their asset prematurely, potentially missing out on future gains.
3. A side benefit of the using options is that they can increase the tax efficiency for investors as we don’t have to sell shares to create downside protection.
In our case, the put option would protect our Apple stock from the first 14% of any potential drop. So, if Apple dropped back to where it was on January 1, the pool would still keep the gain it already had. If Apple dropped 20%, the pool’s net holding would only drop about 6%.
When it makes sense, we are trying to lock-in some of the gains we’ve already had without having to sell out of investments we still like. We owned several other investments that jumped significantly in January and we added option collars for those as well. This reduces our downside risk and still provides potential for further gains if markets continue to rally.
We continue to seek other ways to enhance the returns, or reduce the risk, in the pools but thought this might provide greater understanding…and a little more peace of mind.
Michael Holden
Portfolio Manager
Q Wealth Partners
