Advisors, under pressure from clients to avert new losses like those that hammered portfolios in 2008, are increasingly turning to portfolio insurance strategies.

Among those most widely used are put and call options, inverse exchange-traded funds and tactical asset-allocation strategies. Their aim: to protect client portfolios from "tail risk"-losses typically greater than 30% that fall 2.5 standard deviations below mean returns.

While many advisors may be sick of hearing about standard deviations, one out of every five trades at TD Ameritrade today involves options, says Steve Quirk, the company's managing director of trading. Most frequently, advisors and investors are selling cash-secured puts to establish long stock positions. This arrangement allows the investor to buy a security at a price lower than its current trading level.

Financial advisors are also selling covered call options against long positions in exchange-traded funds and stocks to improve performance. The income from the covered call options cushions the portfolio against losses if the market declines. However, if the market rises, the stocks can be "called away" by other investors, forcing a covered call holder to give up the stock and repurchase it at a potentially higher price. Quirk warns that advisors should be wary of selling calls too close to the money.

In today's world, portfolio insurance makes sense. There have been massive stock market declines in the past 23 years-in 1987, from 2000 to 2002 and again in 2008-even though, according to mathematical probability distribution, these kinds of losses are supposed to occur only once in a lifetime.
And Robert Wiedemer, an economist and co-author of the 2009 book Aftershock, foresees yet another such "fat tail" event in the financial markets. "Fat tails exist in financial market returns," he declares. "These tails can severely affect performance for years as investors re-evaluate their portfolios and asset allocations."

Still, even if hedging programs offer one solution, there is no free lunch with them. In a rapidly declining stock market, the cost of writing covered call options or put options is prohibitively expensive. Besides enduring transaction costs, investors can get whipsawed by market timing.
Hedging programs are not perfect. Adjustments must be made in real time.

"Actual experience will undoubtedly develop differently," says Lawrence Carson, vice president with RGA Reinsurance Company in Chesterfield, Mo.
"Over time, you will be over or under hedged with any hedging program."

TD Ameritrade's Quirk says advisors frequently engage in option overlays. This involves taking a long and short position in the market by writing calls and selling put options. As a result, the risk exposure of the stock or exchange-traded fund is reduced.

Other moves to reduce risk include:
A bear put spread. With this, you sell one put and buy one put at a higher strike price.
A put back spread. Here, you sell one put and buy two puts at a lower price.
A bear split strike price combination. This means you buy a put and sell a call at a higher price.

There are a number of portfolio insurance software programs that help advisors hedge against losses. These mathematical models tell investors when to use derivatives, based on stock market beta values and other measures of volatility. The hedge should have a strong negative correlation to the assets in the portfolio.

First « 1 2 3 » Next
To read more stories , click here