Market Theory and Portfolio Management 273 in C#.NET

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Market Theory and Portfolio Management 273
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also make excellent hedging instruments for systemic risk If you are a long investor in ETF or futures products in broad indices, option trading strategies for defense against negative economic conditions need to be looked at The dif culty with broad indices is the hedge cost versus the return Leaving out 2008 for the time being, we can fairly state that the S&P 500 has had an average annual return of around 10 percent There were years with 20 percent plus gains and a few with 20 percent or more lost In 2008 the S&P lost 386 percent, the third largest drop since inception Let s take the S&P 500 and look at three different strategies for systemic risk control that also could be utilized in narrow-based applications With an average annual return of 10 percent, we can use that 10 percent as our focus point for an option premium in a covered call style Let s say hypothetically the SPY ETF is trading at around 9200 Ten percent in either direction is just under 10 points We assume that the SPY 102 call option for September is trading at around 220 with 140 days left If we sell this call option, we bring in just over 2 percent of the value of 100 shares of SPY over 140 days Selling this call option caps the gain for the SPY shares during the period to 12 percent If the market rises beyond the 102 during the period of the option s life, you can be satis ed with the 12 percent or remove the option at expiration and allow the shares to continue Selling this call option also reduces the risk to the shares by 2 percent It is not a signi cant bene t, but in contrast to outright holding it is a minor improvement If you were able to execute this trade twice over the course of the year, you have the potential to increase the pro tability of the 10 percent average annual return by 4 percent If we take this a step further and bring the option premium closer to the market, we pick up a signi cantly larger premium The 94
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call in this scenario is trading for 550 In selling this call, we bring in roughly 6 percent of the total value of the spread and leave just over 2 percent gain potential for the market We have reduced the potential gain for the market over the course of the option s life to 8 percent, but we have added 6 percent to our risk protection So over the course of 140 days if the SPY is above 94, we will have an 8 percent gain and the ability to remove the option according to your objective or at expiration We can also allow the short option to offset the SPY with an 8 percent gain in 140 days Managing this position twice in the course of the year can add up to enhanced gains over the average annual return of the S&P The broad-based ETF is an excellent tool for managing systemic portfolio risk If we look at using a short market position in a broadbased index against an individual component or sector-based portfolio, we can accomplish a reduction in overall risk without limiting the strength of individual returns Narrow portfolios have higher risk because of the reduced diversity and theoretically higher returns By utilizing a risk strategy on a broad index versus your sector investment, you decrease the systemic risk to the portfolio along with leaving a larger portion of the upside open for pro tability on the sector-based indices The outright short call options or the risk reversal are the best positions to use to offset risk across the broad indices When you are outright selling a call, you are not able to set a oor, but you are bringing cash against the potential downside risk in the portfolio The risk reversal of buying a put and selling a call option allows you to place a oor on the broader market while the sector or individual investments remain intact You must use care when buying put options on broad indices With the average 10 percent return for the S&P 500, it is very easy to spend 10 percent of the index in put premium over the course of the year, which leaves you with
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