Creating Free Options

Creating Free Options

?We must dare to think `unthinkable? thoughts. We must learn to explore all the options and possibilities that confront us in a complex and rapidly changing world. We must learn to welcome and not fear the voices of dissent. We must dare to think about `unthinkable things? because when things become unthinkable, thinking stops and action becomes mindless.? - J. William Fulbright, March 27,1964.

Having a good plan is crucial to investment success, and this involves thinking not just about what is likely to happen, but also considering what happens if you are wrong. If you fail to plan it is highly likely that sooner or later you will encounter major problems with your investments. The main reason for this is that you become a hostage to fortune, and being unprepared can so easily lead to being forced to take dramatic action, and potentially huge losses, at the wrong time.

In a ?complex and rapidly changing world? we have to realize that we need to embrace change. Dynamic management may be the only way to manage our affairs. The quote above describes the importance of thinking ahead, and being ready for any eventuality, even those that seem unimaginable at the current time, or at least far away from current consensus thinking. To get a good plan for your investments requires a great deal of independent and careful analysis. Consensus thinking is highly dangerous in investment planning, as it so often signifies the end of a market trend, so genuine independent thinking is necessary.

Just as important as setting up your plan expectations and asset choices, is addressing the uncertainty that will still remain. How will you react if the markets behave differently than you expected? Unless you have a perfect ?crystal ball? they are bound to do so at some point. So flexibility is also necessary if you are going to be able to cope with new market developments and circumstances in a timely manner. However, how do you build in flexibility to your planning as the markets evolve?

Planning and flexibility come together very effectively if you introduce free or at least very low cost options into your investment account. If you can do this then, either you have the right position and are making good money, or you have a small or insignificant loss, and any ?bad? or losing position no longer concerns you, as it has automatically been sold. These ?options? come in many guises, but to the extent that you can incorporate them, you become increasingly confident and secure in your investment returns. By building them in to your account not only do your expected returns rise but also your risks decline. Essentially you end up with much more efficiently managed capital.

So what do I mean by introducing free or low cost options into your account? Well I can think of several ways in which you can transform your account in this way. Most obviously you can use options themselves, as well as securities which contain options. However, I would also argue that the most important factor is money management. Every position you have can become an ?option? position if you apply money management to it. The best way to explain this is with examples.

Options
First of all we need to start with options themselves. These instruments are widely misunderstood, and possibly as a consequence are very underutilized by investors. The main point to realize about options is that they are 3 dimensional. The price of an option depends not just on the price of the underlying security, but also on the time to expiry of the option as well as the volatility of the underlying security. This means that options are by definition a dynamic tool. As time passes the price of an option will tend to decline as the time to expiry or ?window of opportunity? falls.

I hear so often that investors are advised to avoid options because most of them expire worthless. This is applying static analysis to a dynamic instrument, and suggests that there is little value in the price of uncertainty, or dynamic management. I suppose this could make some sense if you believed in a highly stable or relatively static world. My experience differs a great deal from this perspective as options have proved to be an invaluable tool for over 20 years, and I expect them to remain so for as far as I can see.

In Market Notes 62 published in January, we indicated that 2006 was highly likely to be a difficult year for equity markets. While we had many assets we wanted to hold for the long term our market analysis suggested it was dangerous not to expect a high probability of a significant setback during the year. As a result I purchased one year put options on both the Nasdaq 100 index and the S&P 500 to hedge portfolios for myself and my clients. During July we have now taken profits on all the Nasdaq 100 index puts. The profit on these puts exceeds the cost of our remaining S&P 500 puts, so clients are now in a position where they now have ?free? option protection for a substantial part of their portfolio for the remainder of the year.

So for a small cost and reduced risk, client portfolios are now in a very strong position in a weak equity market They are better able to maintain good long term positions, and accounts are sufficiently secure to continue to make well balanced investment decisions and take advantage of lower prices. They have also outperformed benchmark indices in the mean time.

Securities that contain options
There are also great opportunities in securities that contain imbedded options. For example last week it was possible to buy a security which produces a worst case return of around 4% per annum for the next 2 years. It also receives an additional return in line with any appreciation in a basket of 5 different Asian currencies against the dollar over the next 2 years. If the Asian currencies fall then the investor still gets 4% per annum. This is an outstanding potential return for the risk the investor is taking.

Another security that has an outstanding return for the risk is a new issue of TIPS (Treasury Inflation Protected Securities). If bought near a price of 100 at issue the investor is hedged over the life of the bond against both inflation and deflation. This is a huge imbedded option that is not widely understood. This has been discussed at great length in previous Market Notes, so I will not expand on this again here.

Money Management
The remarkable quality of options can be extended to your whole portfolio by the appropriate use of money management techniques. For example, if you buy XYZ at 100, you might impose a stop on your position if it trades down to 80. A loss of 20 may seem like a large loss but it probably will not happen with good asset selection and timing. Also if you have invested just 2% of your portfolio in XYZ, this worst case outcome will lose you just 0.4% of your portfolio. Unfortunate, but this is hardly a disaster. Alternatively, if XYZ doubles in price you can sell half your position which means that you have recouped your initial stake, booked a profit of 1% and your remaining position is already paid for, or essentially free of cost.

If you start to manage your account in this manner you have essentially turned your share purchase into an option position with no expiry date. If the position works out and XYZ doubles you will have created a free option on further rises. There are many variations on this approach but this simple example demonstrates the power of even simple money management.

By expanding this approach across your entire portfolio you will soon find that your overall level of risk is much reduced, while your returns improve. Positions that fail to perform will automatically be cut out of your account, while your good positions will be allowed to run for substantial profits. It may mean that you will end up with a higher level of cash to reinvest but this will allow you to refocus on new areas or opportunities as the markets develop, while getting rid of poor positions.

Summary
For the most part investors want to talk about what to buy and sell and when. There is no doubt that this is important, but so often there is very little discussion about other areas of asset management that are just as important.

This note has focused mainly on the idea of using many different types of options and money management to significantly improve the efficient management of capital. In a complex and rapidly changing world, investors need a framework that will enable them to dynamically manage their account in an efficient and timely manner. Using options, together with an appropriate money management system not only helps investors make decisions, but it can also significantly improve their returns while minimizing risks.

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