The Elusive Goal: Low Risk and High Yield
The elusive goal for every trader is to achieve the combination of low risk and high yield. Is this ever possible?
The market invariably brings you both good news and bad news. The bad news: Markets are volatile and risky, and any capital placed at risk could result in losses, at times catastrophic losses. The good news: These market risks can be hedged effectively using conservative options strategies.
Coupling the words “conservative” and “options” may seem surprising, since the long-standing reputation of the options market has been exotic, high risk, and inappropriate for many if not most investors, both institutional and retail.
This does not have to be the case.
The options market is becoming increasingly recognized as much more than a form of pure speculation. Today, growing numbers of investors are recognizing that options are most effective as tools for managing a portfolio, reducing and eliminating its risks through hedging strategies, and improving profits.
This book demonstrates how a conservative portfolio can be made safer and more secure, while increasing income. This is accomplished through the combination of equity positions with specific and conservative options strategies. The intention is not merely to augment net profits but to protect the profitability of the equity side of the portfolio as well. This idea is dramatic in the positive effect it has on an institutional portfolio.
The problem every investor and trader faces is twofold: First and foremost, investment decisions must be conservative enough to protect against losses. It means that many opportunities must be passed up because the risks are perceived as too great. Second, the goal must be to match and beat inflation and taxes, the double impact that demands seeking higher returns.
How can you seek higher returns in this portfolio, while continuing to observe the essential demand for conservative strategic management?
Many market insiders and experts are pessimists on this question. They point out that your chance is only through broad diversification of risk, and complex asset allocation as management tools. Both ideas present profound problems for every portfolio. Broad diversification means trying to attain the “vanilla” medium return of the market. A majority of mutual funds, for example, are broadly diversified but they underperform the market average. In fact, according to one source, the average actively managed stock mutual fund returns much less than the overall market. In 2017, the returns for the three major indices and for mutual funds were:
|
Dow Jones Industrial Average |
25.08% |
|
S&P 500 |
21.83% |
|
NASDAQ |
29.64% |
|
U.S. mutual funds |
18.26%1 |
It was not just a one-year dismal report. Making matters worse, even beyond the average outcome, most funds perform beneath the average of the broader market. One study concluded that over 15 years, an average of more than 90 percent of funds reported yields lower than the overall market:
|
% yielding less |
|
|
than market average |
|
|
All mutual funds |
83.74% |
|
Large cap |
92.33% |
|
Mid cap |
94.81% |
|
Small cap |
95.73% |
|
Average |
91.65%2 |
Why is this so? The answer is at the crux of the message in this book. Any observer of the mutual fund performance phenomenon would wonder why the average mutual fund underperforms market averages and why most funds perform under market averages.
The three disadvantages mutual funds have over other institutions (e.g., insurance companies, banks, pension plans, and specialized advisory service provides) include overdiversification, fees, and requirements for cash on hand. Mutual funds—notably very large ones—may simply hold positions in too many segments of the market, so that their returns are going to be average at best. Returns are further diminished by fees that mutual funds charge (1.44 percent on average). Finally, funds hold between 3 and 7 percent in cash to meet obligations, and this “dead money” does not earn.
Other institutions that may be less concerned with competition or with performance reporting are not as likely to suffer from this dismal outcome. However, an underlying problem is that every investor, whether an individual or a portfolio manager, must contend with the desire for better returns without higher risks. This is a daunting task; but the options market addresses these concerns and improves chances for meeting both otherwise conflicting goals.
A central theme of this book is to analyze the possibility for matching acceptable risks with better than average yields. Most experts question the idea that risk-averse investors can outperform the market averages. However, this book challenges the conventional wisdom by demonstrating how conservative investors can exploit a narrow band of potential strategies, dramatically increase yields and, at the same time, manage risks within their self-defined risk limitations.
Risk is at the core of all ideas for portfolio management. If a range of strategies contains too many pitfalls, it is not worth pursuing. But a basic premise in this book is that a conservative investor is not necessarily someone who does not want to expand beyond a well-understood and short list of investment possibilities. Being a conservative investor does not necessarily mean that you are unwilling to examine new ideas, expand your portfolio, or take acceptable risks. It just means that you are not interested in speculation or in exposing yourself to the possibilities of high risk. This applies to personal comfort levels or preferences and to internally imposed standards and limits. Many investors attempt to carefully define acceptable risks with the intention of avoiding unacceptable losses. This translates to a complete ban on options trading, and for good reasons.
In the recent past, abuses of derivatives trading created many losses and a troubling question about whether those individuals making portfolio decisions represented the investment policies of the institution. In 2008, many options-based institutional trades resulted in massive losses, including Morgan Stanley3 ($9.6 billion) and Société Générale4 ($6.6 billion).
These losses do not include losses in futures or credit default swaps, which in many cases were even larger. Even so, the options market has received the worst press as overly risky, often abused, and far too speculative for conservative investment managers or individual investors.
It is true that a lack of experience or awareness of risks most likely leads to large losses. It is not enough for an institution to rely on an individual who has studied options and passed the FINRA Series 4 exam (Registered Options Principal) if that person does not have experience in trading and is not aware of the range of risks in speculative trading practices.
This book offers a realistic definition of “conservative investing” which is a series of polices practiced by those experienced enough to be aware of both yield and risk and who make decisions based on awareness. Conservative investors are not as likely as other investors to be taken by surprise when they lose money in the market. Another aspect of this expanded definition distinguishes between risk profile and the willingness to use creative and alternative strategies. Conservative investors are not close-minded and do not reject exotic instruments like options merely because of their reputation as high risk. Instead, well-informed conservative investors are likely to examine claims about high-yield potential with an open mind. You may be skeptical and, at the same time, willing to listen to the suggestion that the combination is at least possible. A limited number of strategies do, in fact, offer the potential for conservative applications to meet the three goals common to conservative investors: preserving capital, avoiding unacceptable risk, and protecting profits.
This book does not suggest that you must become an expert in a broad range of complex or exotic options strategies. Instead, it proposes a limited number of strategies appropriate for conservative investors. This approach respects the limitations in the conservative risk profile while showing how experienced stock market investors can expand their yield levels significantly, protect existing positions, and come through market down cycles intact.