Long-term and options
Equity options, especially ones based on broad ETFs, are an often overlooked but excellent long term investment tool. They tend to buffer short terms market movements in either direction giving the long term investor a bit more time to analyse news releases and act accordingly. In turbulent markets they can offer absolute protection against extreme market drops. In side-ways markets they offer a way to increase the yield on your existing investments. However the best thing about options is that they allow an investor to fine tune the leverage of their portfolio while at the same time eliminating tail risk.
Benefits of using options
The charts below compare the historical returns of an investment in the SPDR S&P500 ETF (Regular) versus the returns using a one-year roll-over of options on the SPDR S&P500 ETF (Optionized). The Year-to-Year chart compares the returns achieved in each year in percentage terms.
*The chart is based on actual historical data for the S&P500 index since 1950. The optionized line is created using the same historical data and the option attributes last updated on Jan 25, 2012 based on that days market prices.
Go ahead and play with the attributes above to see how you would have done!
Options can protect a portfolio from extreme market drops and cap the amount of loss that is possible in any given year. In years when the stock market crashes an option based portfolio significantly outperforms a similarly leveraged portfolio as you can see in the Year-over-Year ROR graph above. The approach cannot prevent the loss of money during a market crash but it caps that loss at an absolute amount. This is very effective because the aftermath of a market crash is usually the best time to invest.
If you play with the Leverage drop down above you can see how you can easily change your risk level and therefore return by simply adjusting the amount of leverage you take. Keep in mind that the actual investment never changes even though the results change dramatically. Option investing can help you adjust the risk without affecting your investment strategy.
Investing inside registered accounts is often constrained by various borrowing rules. Options may be an excellent way of getting around those restrictions.
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