Capital Market Armageddon Insurance


Investing for the Long Term, While Protecting the Short Term

John A. Kvale CFA, CFP
1-15-2012

Due to capital market movements over the last ten years, and specifically 2007-2009, we set out to discover possible ways to protect investors from Armageddon scenarios which may quickly detract large amounts of capital from portfolios.

Our goals were:

    1. Attempt to remove Armageddon scenarios from investor’s portfolios by dramatically limiting losses of a properly diversified equity portfolio, coining the  phrase “Investing for the long term, while protecting the Short

    2. Formulate a plan that would stay in place for the long term once established, thereby protecting investors across the risk, and age, spectrum

    3. Keep the cost low. Our studies revealed effective strategies, but at costs from 2-8% annually, which were unacceptable to our reasoning

    4. Continue investor portfolio’s upside market appreciation

    5.Keep the process simple and add value through our firm’s competitive advantages

    6. Research in advance as many possible ways to accomplish these goals

    7. Be open to taking advantage of all possible liquid markets

When we started this series, our thinking was capital market movement would be volatile in the coming election year, 2012, thereby giving us the full year to deliver this information to you and then allow time for continued research and digestion. Markets, as in life, did not completely cooperate, and became volatile THIS year, forcing us into the experience curve a bit faster. Now that the events of 2011 have occurred, we continue to be pleased with the results and in hind sight are glad they transpired.

We started our research in the mid 2000’s and were spurred by our findings, client encouragement, and continued capital market movement.

To summarize our final outcome, we believe we have established a way for “Investors to invest for the long term, while protecting the short term” Coined by Donald Capone III CFA 

In our research, especially of the 1987 portfolio insurance scenarios, we found that many types of Armageddon scenarios did not work at the most important time they were needed, which was an alarming possibility to us. This fact drove us away from the futures markets, stop loss, dynamic portfolio adjustments, and counter party risk scenarios.

We eventually determined given our firm’s economic advantages, market offerings and current environment, an Armageddon Option Collar was the correct plan for us.

With Option Collar studies and systems being utilized for some decades, we were pleased with the historical research we could review, and felt with our competitive advantage adjustments, we would achieve our goals.

Our use of options is not a get rich quick idea you may see or hear of on the various public airways.

Our use is actually intended to LOWER risk, and is similar to what Mortgage, Energy, or Airline companies use to lower their risk. All of these uses are to lower risk. Our use, as is theirs, is a conservative solution. 

After extensive research, discussions with CBOE (Chicago Board of Option Exchange) professionals, and greater liquid options markets, we implemented the Armageddon Option Collar protection in February of 2011. We have been pleased with the results and performance. We found the results very impressive during the capital market movements of August, and have been pleased with the accomplishments of our goals.

Over the past year, we have made a few enhancements that will allow for even better protection in our opinion, and will continue to monitor ideas for possible future adjustments.

The Armageddon Option Collar entails buying a long dated put option to approximately protect equity portfolio movement to the down side, while also selling a short dated call option to help offset the cost of the Collar. We have added the purchase of a matching short dated call option in order to continue with investor portfolio capital appreciation participation given the recent volatile market movement.

Strategies such as this are note easy to explain in a word format, and as such, we will continue to discuss our Armageddon protection in future articles. We also plan to show this in a more graphical manner.

Here is a short review of the basics investments we use in order to move toward our above stated goals.

What is an option?

Derivate, a Wall Street fancy name and broad definition of an option, is an instrument where value is determined by the movement of another financial instrument. Said another way, an options’ value is determined by the price change of something else, therefore, an option is never a standalone value.

There are basically two types of options, the Call and the Put

A call option is the right to buy an investment at a certain price and a put is the right to sell or put the investment at a certain price.

The Put Option expanded:

A Put option in its most basic form has very similar characteristics to insurance. You might find it helpful to think of a put option as your fire insurance on your home. You pay for your insurance, usually a year at a time, and if something terrible happens, your insurance is there to replace the damage done. It is also very important to remember, if nothing happens to your home, you do not receive a refund of the premiums paid, you were just covered and slept better each night knowing you had protection.

Often times the cost of insurance for a portfolio may run in the 6-8% of the portfolio balance range per year. In our minds, as a standalone cost this is entirely too much, and will most certainly chew up sizeable gains, year after year of your portfolio.

The Call Option Explained:

Given that a Call option gives an investor the right to buy investments at a certain price it’s value is derived by appreciation in the underlying investment. For our purposes we sell an investor the right to buy the investment at a higher level. Think of it as selling a much higher sales price of your home to pay for the Fire Insurance/Put option mentioned earlier. There are various in-house proprietary items that we do in order to maximize the value of this right such as time length, and amount, which are beyond the scope of this article, but we feel the ability to add substantial value in this specific area along with others mentioned before. The most important item to understand is that if the portfolio/house dramatically rises in price, as the investor/owner we may only see a portion of that appreciation.

 

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