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Equity Investments Enhanced with Derivatives

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.


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6 Responses

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  1. bgpl says

    nice post !
    how exactly is the dynamic VEQTOR calculated ?
    also, how is the investment made in implied volatility ? VXX / VXZ ? futures ?
    would you be able to provide some references for the above ?
    Just curious, thanks.

  2. SurlyTrader says

    I will discuss it later, but VEQTOR invests in S&P 500 and a dynamic allocation to the S&P 500 VIX Short-Term Futures Index (VXX). The strategy tries to fine high/low volatility environments and invests in VXX based upon realized volatility environment and implied volatility trend. It is systematic.

  3. NGB says

    Excellent post as usual, I think it follows up on the one about volatility selling strategies from last Agust, well thought derivatives strategies have a better risk/reward ratio that long only, it really amazes me how people keep uisng buy and hold. By the way, do you have the link to that Barclays Volatility Selling Strategies orignal paper?, I would like to see how they build their indeces so I can do it on my own with more assets. Thank you very much!!

  4. Sid says

    Will appreciate if you can post a follow up article on various strategies using implied vol along with equity positions.

Continuing the Discussion

  1. Understanding the S&P 500 VEQTOR Index | SurlyTrader linked to this post on July 29, 2010

    […] that directly enhance long equity positions with option overlays. I have covered the enhanced Sharpe ratios (risk-adjusted returns) that often accompany these strategies.  I was surprised to find out that Direxion is going to bring the S&P 500 Dynamic VEQTOR Index […]

  2. Understanding the S&P 500 VEQTOR Index | Smart Stocks Investing linked to this post on July 30, 2010

    […] that directly enhance long equity positions with option overlays. I have covered the enhanced Sharpe ratios (risk-adjusted returns) that often accompany these strategies. I was surprised to find out that […]

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