One way around the above drawbacks that can still reduce market risk involves the use of index options. Instead of buying or selling options on each individual stock, the portfolio can be treated as a unit and the unit’s market risk can be hedged with the use of index options. This strategy will help offset the losses in the portfolio that are caused by a general market decline while allowing the potential outperformance of the individual stocks to remain unaffected.

Instead of individual stock positions being called away, the portfolio remains intact while the profit and loss of the index option position offsets losses and gains in the stock portfolio to varying degrees depending on the diversification of the portfolio and the effectiveness of the hedge. The use of index options streamlines the management process of the option hedge as the entire portfolio can be hedged with the use of a handful of option positions.

Options can be a great tool for managing risk in many types of markets, and the recent introduction of various “alternative” investment portfolios in mutual fund form makes it easier than ever to take advantage of the strategy. The ability to dampen volatility and provide downside protection may be particularly attractive now, as advisors and their clients grapple with the potentially disruptive effects of a return to a more normal interest rate environment.

 

Alan Salzbank is a co-founder of the Gargoyle Group, a leader in developing and executing options-based investment strategies, and co-portfolio manager of the RiverPark/Gargoyle Hedged Value Fund (RGHIX-Institutional; RGHVX-Retail).
 

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