Diversify Investments with Options
- Written by Chris Fordinal
You know it’s important to diversify your investments. But do you know how? We’ll explore using options on an inverse index to insulate your portfolio.
Diversify, diversify, diversify! It’s the “location, location, location!” of the investment world. Even if you’re not interested in the stock market, you know that a good investor diversifies his or her investment portfolio.
It’s the first bullet point in Investing 101; however, knowing that information and knowing how to apply it are two completely separate things. I know how multiplication works, but if you ask me to multiply 20,495 by 394,740, I won’t be able to apply that knowledge quickly or effectively.
In order to solve the problem quickly I need to turn it into a series of smaller problems. Don’t worry, I’m not about to give you a lesson on how to solve complex math problems—you have an iPhone for that. Instead, I want to offer a way of diversifying your investment portfolio that you may not have tried before.
We are going to explore the use of options on an inverse index to help insure your investments in the stock market against loss. I almost felt fancy writing all those finance terms in one sentence. I swear to never do that again in this article. Lets break it down into simple pieces.
In order to understand the use of an option on an inverse index you need to have a grasp of what an inverse index is and what an option is.
Let’s begin with what an inverse index is and how it works. The stock market has thousand and thousands of stocks being traded every day. Included in those thousands of stocks are individual companies (think Apple, Dell, AT&T) and indexes (like the Dow Jones, the S&P 500, and the Russell 1000).
An index is simply a collection of stocks. The Dow Jones Industrial is likely an index you hear a lot about. It sounds very highbrow and intimidating, but all it contains are the shares of thirty individual companies.
So, if you buy one share of the Dow Jones Industrial you have essentially just bought a small piece of one share from multiple companies. There are all kinds of indexes on the stock market, some combine stocks from a particular industry (HGX combines companies in the housing market) while others bridge the gap and focus on combining top performing companies from multiple industries (the Dow Jones Industrial).
Indexes give an investor a quick and easy way to insure he or she is diversified. If you own stock in an index that focuses on the medical field and one company in that index falls drastically, you will be protected because your shares are actually split up into many different companies.
Indexes provide a great way to invest in the future of an industry or the overall market. For the many people putting their money into Betterment, Vanguard, or a similar service, you will see that much of those funds are not put into individual company stocks but into a group of indexes.
This allows your investments to be diversified in two ways. You are invested in multiple indexes and those indexes are invested in many different individual stocks.
The concept of an inverse index is relatively simple once you understand normal indexes. The inverse index is merely the opposite (or inverse) of another index. It’s like you have an etch-a-sketch that automatically draws a staircase in the direction the stock market is headed for the day.
If the stock market is headed downward that day, your Etch-A-Sketch will have a stair case that goes downward on it’s screen. If the market is going up then the screen would show a staircase heading up.
Now let’s say you have an Etch-A-Sketch that draws a staircase that does the opposite (or inverse) of what the market is doing for the day. If the market were headed up (on the left of the picture below) then your screen would show a downward staircase for the inverse index (on the right side of the picture below).
Many inverse indexes achieve this opposite effect by utilizing a strategy of sell in the morning and buy in the evening. That means that when the market opens in the morning these inverse indexes sell all of the assets they bought the evening before.
Then (later that same day) when the market starts to close, they buy all that they sold in the morning. Look at the picture of the Etch-A-Sketch below: do you see the little arrows at the beginning and end of the trading days? Those mark when the inverse index bought and sold the market.
You will notice that when the market is going down (which means the inverse is going up), the inverse index sold their stocks for more and bought for less. They end up making money because they could have sold 10 shares for the higher price, then bought those same 10 shares at the lower price, and kept the difference.
If the market continued down the next day they would repeat these steps and make more money. Now, take a look at the next picture (below) and you will see that when the market goes up, and the inverse index goes down, they will be selling their shares for less than what they bought the shares for the day prior. Therefore, an inverse index only makes money when the index it is following goes down in price.
The final twist on indexes is that they can be multiplied. That sounds complicated but all it means is that instead of buying one share, an index buys multiple shares. Buying more than one share will increase (or multiply) how harshly the index responds to what the market does.
If you buy three shares of every stock in the Dow Jones and I only buy one of each, than you will have three times the profit or three times the loss I have, depending on which way the market goes. This multiplication effect can be applied to both indexes and inverse indexes.
If a normal index went down 1%, then it’s inverse index would have gone up 3% if it bought three shares per company instead of one. There is much more than this to learn about indexes and inverse indexes, and I encourage you to research how it all works, but this is an introduction.
The second thing we need to understand is what an option is. Just like indexes, there is a ton of information I could try to jam into this article, but for now, let’s just cover the basics. In simplified terms, an option is the right to buy or sell someone else’s stock.
For example, I have a hundred shares of Apple that are currently worth $100 a share and you want to buy them from me but don’t want to pay the market price. You could make a deal with me by that you would give me $500 for the right to buy my shares at $125 a piece during the next six months.
I would then be contractually obligated to sell you my hundred shares of Apple for $125 a share anytime during the next six months. If (during that six months) the price of Apple’s stock went higher then $125, you would do one of two things. You would either come to me and say “Hey! I want to buy those hundred shares now!” and I would sell them to you for $125, which would mean you could then go sell them on the market for more.
Or you would sell your right to buy them to another person for more than what you paid me. The latter of the two means that you do not come to me and buy the stocks (which would be referred to as exercising the option) but rather you transfer the contract you made with me to be between me and another buyer.
The thing that makes reselling the right to buy an easier route than the other is that it doesn’t require you to have as much money. If you want to exercise that option, you would have to go to the person you made the agreement with and say “Here’s $125 for each of the hundred shares” ($12,500).
Once you bought the shares, you could turn around and sell them on the market for whatever their current value is; however, this requires you to spend $12,500 plus the original $500 you paid for the right.
It would be amazing if options always worked and you made money 100% of the time, but (just like any other investment) there are risks. If you buy the option to purchase my hundred shares of Apple for six months and the price of Apple stock never makes it as high as the agreed upon price (called a strike price) of $125, then I would get to keep the $500 you paid me and you would get nothing.
When an option runs out of time, it is said to have expired. Once your option on my Apple shares expires, I could then go out and sell the option for another six months to someone else.
The types of options discussed above are named call options, meaning that you have the right to call in someone’s shares and buy them at the set strike price. The other type of option is called a put.
Put options give you the right to sell someone’s stock at a certain strike price. If you applied the situation we used above, it would be like you coming to me and saying, “I’ll give you $500 for the right to sell you a hundred Apple stocks at $75.”
You could make this deal with me even if you didn’t own a hundred Apple shares at that time because you would only exercise the option if the price of Apple’s stock fell below $75. If the stock did fall below $75, you could buy it on the market for less and sell it to me for $75 a share.
You could also sell the put option to another person for more than what you paid me. Essentially, a call option is used when you think an index or stock is going to go up, and a put option is used when you think it’s headed down.
Making Money From Options
There are many different ways to make money from options but in the strategy I am going to discuss will be about buying call options. If you’re interested in trading options, you should do a vast amount of research before you begin. There are some special types of options that can really get you in trouble if you’re not sure of what you’re doing.
Buying options is different then buying stock because you don’t buy options on a per share basis. You buy them per contract. A contract will give you the option to have control over a hundred shares of that specific stock or index.
Occasionally a contract could refer to less than a hundred shares, but it’s rare. If you think back to the example above (when you were purchasing the right to buy a hundred shares of Apple from me) you would have bought one contract for $500 and you could have exercised that contract to buy a hundred shares.
I don’t want to make any of this confusing so the picture (below) is what you would see if you went onto a trading platform to buy options.
The following labels are listed from top to bottom and left to right:
- Stock price – this is the current market price of the stock itself.
- Date – this is the amount of time left before the option would expire.
- Calls – these are the different call options available
- Puts – these are the different put options available
- Bid – the number on the left is the bid. it shows how much someone is currently willing to pay per share for that option.
- Ask – the number on the right is the ask, which tells you how much someone is willing to sell that option for per share. You must keep in mind that you will have to buy at least one contract (which is normally 100 shares) of either the bid or ask prices. So the bid of $1.61 would mean you are going to pay $161 (plus fees) per contract.
- Strike – this is the price at which you will either be able to buy the stock (when using call options) or sell it (when using put options).
With all that ground work done, we can actually dive into using options on an inverse index to hedge against loss within your stock market investments. (I swear that was the last time the fancy finance jargon will come in!)
One of my friends likes to call this strategy his, “investment insurance” because he hopes to never use it but he is glad he has it. The idea is to buy call options on an inverse index that is the reverse of the market you are worried may tank.
I won’t claim that to be a market wizard or to have the ability to predict when a correction is coming; however, this strategy was spawned because there are many people worried that the market has a correction in its near future.
You should do the research and decide for yourself whether you think that is a possible threat to your investments in the short term. Even if you do not think a correction is going to happen, there is knowledge to be mined.
To help me explain this idea, I’ll use an inverse index with the ticker symbol FAZ. FAZ is an inverse index that is run by Direxion Investments and tracks three times the opposite of the Russell 1000. The Russell 1000 combines the largest 1000 companies on market into one index.
By doing so the Russell 1000 accounts for approximately 92% of all the market. Meaning, if the market goes up, so will the Russell 1000, and if it goes down, the Russell will follow. Since FAZ is the three times inverse of the Russell 1000, it will go up three times as much as the market goes down and vise versa.
In the name of diversification and being protected from a market crash, you could just spend a solid portion of your investment portfolio on FAZ and other inverse indexes like it; however, that would require a lot of money and slow your growth down significantly.
For instance, lets say you have portfolio that is valued at $100,000 and the market takes a big loss of 10%. That loss now makes your $100,000 worth $90,000. Now lets say that (before the downturn) you bought into FAZ in an attempt to cover potential loss.
Since FAZ is three times the inverse of the market it should have gone up about 30%. You would have had to buy 2,667 shares of FAZ (before the market went down) at a price of $12.50 (the price of FAZ on Sep. 21, 2015) to make enough money and cover the $10,000 loss you took.
The money required for you to buy into FAZ originally would have been $33,337.50, for 2,667 shares. That means you would have had to put 33% of your original portfolio into FAZ, which isn’t very diversified.
The reason that options allow this strategy to work is that they require much less money to have control over the same amount of shares. Take the same example as above except this time lets say you bought call options on FAZ instead of buying the stock itself.
The call options you buy have a strike price of $12.50, are good for the next 4 months, and cost you $160 a contract (which controls 100 shares). In order to control the same amount of stocks you had before (which was 2667 shares for $33,337.50) you would need 27 contracts for a total of $4,320.
What’s interesting about how options function is (just like stocks) they can be overbought and oversold. In times when the stock is running up or down very quickly, the options prices will skyrocket or plummet.
In the past, when the market has dropped 3% quickly (which made FAZ go up approximately 9%, the options have done more (percentage-wise) then the FAZ stock itself. At the end of July you could have purchased call options on FAZ at a $40 strike price (which is a very high strike price), for a length of 6 months, for $0.12 per share or $12 a contract (plus fees).
At the beginning of August the market had a day where it dropped very hard, and those options went to a high of $1.00 per share or $100 per contract, which is over a 900% increase.
Now, no one should go running to their smart phones and start trying to get rich quick. Who knows what the market will do, and trying to predict it is a fools game.
But I explain this to you because if you’d put in $2400 and only sold your contracts at $60 each (instead of the high of $100) you still would have made a profit of $10,000 and been able to cover your losses without having to have gone through the pain of ever exercising
That’s $10,000 profit when the market only came down 3%, giving you significantly more than what your portfolio would have lost for the day. Keep in mind that the momentum the options gather in a correction or falling market allows you to keep your investment cost low while still protecting against a market downturn.
Also keep in mind that you should not invest in these options because you think you could make 900%. The idea is to put a small amount of funds into those options to protect against a possible correction.
If the market never corrects, and your options are never profitable, than you should view it as a good thing. The numbers above are not meant to be indicative of results but are meant to demonstrate how these options react to drastic downturns in the marketplace.
Again, it’s like paying your insurance company your premium every month; it’s not money you expect to get back unless something goes very wrong. Be that as it may, it is a worthwhile research topic for times that you feel the market is headed for a downturn.
I’m not the man who will teach you to be rich, nor will I tell you the secret sauce of Wall Street. In my experience, there are many people who feel that they cannot delve into the world of Wall Street and finance without a degree from some Ivy League school, and I want to challenge that thinking.
Featured Image Photo Credit: “IMG_0943” by Anne White on Flickr