Payoff Diagram

Q&A with IFA: Reducing Risk with Options

Payoff Diagram

Question: Can put or call options be used to achieve a more predictable risk-return tradeoff? For example, should I purchase put options to minimize equity portfolio losses?

Note: The question above was originally addressed in DFA’s Fama/French Forum. They gave the following response:

“This strategy does reduce your downside exposure to equity, but the insurance is not free. Buying the put leaves you with less to invest in equities. In other words, you have to sacrifice part of your upside return to protect against downside loss…It is important to remember that someone has to bear the downside risk on your equity portfolio. The risk does not go away when you insure your portfolio by buying a put; it is simply transferred to whoever sold you the put. You should buy protection only if you think the insurance is underpriced or you have an unusual utility function. If you are motivated by simple risk aversion, you would probably be better off reducing your overall allocation to equity.”

While Fama and French thoroughly addressed the question of buying puts, they did not address the frequently asked question of selling covered call options to generate extra income, so we will attempt to that here.

When an investor sells (or writes) a call option on an equity holding, he collects the option premium, and as long as the security’s price stays below the option’s strike price, the option will not be exercised against him. Essentially, selling the call caps the upside of the security’s value while doing little to protect the downside. Of course, the investor could use the proceeds of the call option to buy a put option, thereby creating a “collar” for the security.  At that point however, the investor has essentially taken a high risk/high expected return investment and transformed it into a low risk/low expected return investment.

The performance of the largest exchange-traded fund that engages in a buy-write strategy, PowerShares S&P 500 BuyWrite ETF (PBP) indicates that far from being a money-maker, selling calls can be extremely costly in a market that has gone up, of course nobody knows for certain where it is going next. According to Morningstar.com, for the five year period ending 6/30/2014, PBP had an annualized return of 9.70% while the S&P 500 Index delivered nearly double that at 18.83%. A $1,000 investment would have grown to $2,369 in the S&P 500 Index, but it only would have grown to $1,589 in PBP.

Echoing Fama & French’s answer on buying puts, selling calls only makes sense if you have special knowledge that they are somehow overpriced or you have a utility function that places a very low value on gains beyond a minimal level. In a freely traded options market, we assume prices woiuld be fair. We also think that traders who place a low value on investment gains would be a rare option trader.

The best strategy is to take IFA's Risk Capacity Survey and invest in the right risk level from the start.