Typical investors using protection
Why wouldn't I just sell my shares if
I'm worried about the market falling?
Investors may consider simply selling down their equities exposure if they foresee a market correction on the horizon. Using cash as a hedge can be a great way to mitigate risk. However that approach does have some limitations which need to be considered.
How we protect portfolios
There are a number of ways to protect a portfolio and various degrees of protection. We generally use S&P/ASX200 index options as they can be closely correlated to a portfolio of ASX shares and therefore reduce transaction costs. Depending on the strategy, costs can range from free through to a percent or two of the overall portfolio value.
Our approach to protection is based on several underlying indicators that allow us to identify potential periods of market weakness. After a decision is made to protect portfolios, the analyst team will attempt to predict the severity and duration of the fall, then formulate an options strategy to mitigate the potential loss.
Often we identify unique opportunities to establish partial protection on portfolios for almost no cost. Your adviser will be able to identify and alert you of these opportunities when available.
The ideal time frame is around 2 months, however for smaller portfolios protection may be purchased over longer periods to reduce the number of transactions.
An adviser will be able to handle the process from identifying opportunities, implementation and ongoing management.
How we predict volatility
Fear & Greed Indicator
The indicators above come together to produce what we refer to as the "Fear & Greed Indicator". In a general sense, this tells investors the value and sentiment of the ASX200 and can be used to determine when it is appropriate to hedge out portfolio risks or take on more exposure.
What are the risks?
We use options to hedge market risk of your share portfolio. Note that the Options may fall in value or become worthless. Changes in the underlying share price may change the Option price, but the option price change may be in a different direction or magnitude.
Options have an expiry date and therefore a limited life. An Option's time value erodes over its life and this accelerates as an Option nears expiry which can be beneficial or negative depending on the strategy.
Leverage can lead to large losses as well as large gains. When investing in options, your initial outlay is small relative to the total contract exposure, a small market movement may have a larger impact on its value.
Option writers may face losses
Selling Options involves risk. If you sell and the position moves against you, you may lose more than any premium received. Where the position is naked, losses are potentially unlimited.
Calls for additional capital
If the market moves against you or margins increase you may have to provide additional funds at short notice. If you do not, your position may be closed and you will be liable for any resulting loss.