Markets: News  

Chuck Jaffe

Market survival needs no fancy footwork

7/27/12 7:25 PM ET (MarketWatch)Print

BOSTON (MarketWatch) -- When average investors start looking at sophisticated ways to play the market, they're just asking for trouble.

Consider Michael in North Easton, Mass.; he's 55 years old, with the last of his kids about to finish college, and is looking for "portfolio insurance against the current market."

He's looking at collars, covered calls or selling puts to hedge bets against growth stocks or high-dividend issues that he thinks could be derailed.

Except that by his own admission, Michael knows almost nothing about those hedging strategies. He's studied them and has been to seminars and talked to a broker, and now he feels like he might be ready to give it a go.

Michael is part of a growing trend. In two decades as a personal finance columnist, I have averaged about one letter a year from an ordinary investor with questions about using options. In just the last two months, I've heard from about three readers per week like Michael.

Covered calls

Maybe it's the problems in Europe, or the lack of bullish sentiment in the marketplace -- an American Association of Individual Investors study pegs investor optimism at a two-year low -- or a market that is difficult to read.

Whatever the reason, the empirical evidence makes it clear that investors are trying to get comfortable in an unsteady market. While the concept is good, execution is everything, and that's the problem for investors like Michael.

It's hard enough for the little guy to find ways to make money in this market; adding a layer of costs won't make it easier.

That said, these alternative strategies are terrific tools for investors who understand how to make them work.

To see their appeal, consider a simple "covered call." This is a strategy where an investor holds a long position in a stock, and sells call options on the same stock, typically because you expect a good long-term future but think the near-term will be flat or down. The options are insurance against your short-term doubts.

Say you own shares in XYZ stock -- now trading at $20 per share -- but were scared by recent announcements in its industry. You sell a call option for $22; you will earn a premium from the option, but you cap your gains and the story ends in one of three ways:

a) XYZ is flat and stays around $20, never reaching the "strike price," so your options expire worthless. You keep the premium from the option which, when added to the $20 shares you own means you have done better than if you simply held the stock.

b) XYZ shares fall to $18, the options expire worthless, and you keep the premium. This is where the strategy acts like insurance to reduce losses.

c) XYZ shares hit $22, and the option is exercised. You sell with a 10% gain plus the option premium, but if the stock keeps going up from there, your tactic -- also known as a buy-write strategy -- has underperformed the stock.

Fixes and solutions

There are countless other options strategies; if this explanation was hard to follow, consider that this is one of the easier tactics to understand. (And to all the letter writers including Michael; if you had to write for my take on options strategies, that's another sign that you don't know enough.)

The whole point in hedging, however, is being willing to pay something in order to limit your losses. Most investors love the idea of limiting losses, but aren't so keen about paying for it (and there are transaction costs, regardless of the outcome).

Further, investors who are looking for portfolio insurance have plenty of ways to limit downside risk, from indexed-annuity products (which try to provide most of the market's gain, with none of its pain) to simply saving more and reducing market risk by keeping more in cash, gold or alternative assets.

"I wonder if people who are thinking about options -- when they really haven't done them before -- should be focusing more on making sure their allocations are correct," said Charles Rotblut, editor of the AAII Journal, a publication of the American Association of Individual Investors. "Rebalancing and getting back to their target allocations would help them do more towards reaching their goals than anything else."

Rebalancing involves pulling money from your winners -- locking in gains -- and investing in some of your laggards to get the portfolio back to the asset mix and weights you initially intended. In that way, it takes money off the table and goes back to your starting wager; that, too, can feel a bit like "portfolio insurance."

The other key question here for most investors is whether their idea of "portfolio insurance" -- through options or hedging or some other strategy -- actually gives them what they want.

Reducing losses is not the same as "getting your money back." Another way of reducing market risk is putting less of your dollars in the path of Mr. Market, so if "suffering a smaller loss" is not what you are picturing -- and that's not Michael's vision of his future with "portfolio insurance" -- then perhaps you should keep looking at your overall investment strategy, rather than simply at hedging strategies with the investments you own now.

"There are a lot of good protective strategies out there, but I don't think you enter any of them lightly," Rotblut said. "You don't just say 'Oh, options will protect me,' and go out and trade them and make money like the pros do with them. You had better go out and really learn something, or hire an adviser who is knowledgeable."

Options and hedging strategies can be wonderful tools for investors who know what they are doing, but average investors run the risk of proving that "a little learning is a dangerous thing."

Yes, protection against downturns would feel great in this market, but only if you can do the job rather than botch it. Otherwise, in these times, you may need protection from yourself more than anything.