Derivatives have been getting a lot of bad press lately and the spotlight will only heat up as the derivatives legislation is debated. Derivatives are often associated with leveraged speculative bets and the negative economic outcomes that often result from these poor levered decisions. Within insurance companies, pension funds, investment banks, fortune 500 companies, and other large institutions; derivatives are utilized to hedge or completely offset undesired risks on balance sheets. Somewhere inbetween these two extremes is an area of derivatives usage in which derivatives provide a way to supplement traditional asset management in order to increase risk adjusted returns.
I will not go into details about these strategies today, but I will expand upon them later. The results speak for themselves.
Covered Call and Cash Secured Put Strategies
On the very conservative side of derivative usage is cash secured option positions. If you own a stock then you write a call option on that stock holding. If you would like to purchase a stock then you write a put option on that desired stock. As a simple comparison, look at the results of a systematic covered call and cash secured put portfolios versus that of the S&P 500 total return index:
Equity Investments with an Allocation in Implied Volatility
This idea is very new in the asset management arena. Instead of purchasing a put option to protect equity holdings against downside losses, we invest in implied volatility directly as a portion of our investment allocation. When equities decline quickly, the allocation in implied volatility increases rapidly.
The actual derivative strategies will be described later, but for now just remember that derivatives are not just simply for hedging. In un-leveraged forms, derivatives can help nearly every investor increase his/her risk-adjusted returns.