Stock market imposed over skyscraper
Stock market imposed over skyscraper

Optionality: Why we use derivatives to manage risk

Note: This is the inaugural blog in a three-part series focusing on how to get returns in today’s bull market while protecting against the downside—in other words, how to run with the bulls without getting trampled.

It’s no secret that we believe equity valuations in the U.S. are expensive. While we don’t predict an immediate, recession-sized market correction, we believe the risk of downside is significantly greater than any remaining upside.

That said, upside potential is still there with the recent fiscal stimulus and new tax bill supporting a late-cycle blowout rally. So, investors end up with two conflicting risks they need to manage:

  1. Downside risk. This one—the risk of loss—may be obvious, but it hurts the most.
  2. Upside risk. This may be less painful. But still, no investor wants to miss out on more market upside. Think of this as the risk of missing out.

At Russell Investments, we often use derivatives as tools designed to protect against downward market moves, but in reality, they help with both kinds of risk. Let’s be optimistic and say that it is possible—albeit unlikely—that U.S. equity markets could still generate an additional 20% return. But if equities are already overvalued, as we believe, then that increase in value may also create a greater likelihood—and a greater scale—of a downside correction. We want to participate in the upside and avoid the downside.

Put options and downside risk

Let’s pause for a little Derivatives 101. Put options are option contracts that allow the holder the option to sell a security at a specified price within a gated time period. Because put options are sell-oriented, the holder benefits if the price drops. For example, we may buy put options on an ETF tracking the S&P 500® Index, giving us the right to sell that ETF at the S&P valuation of 2,625. If the S&P drops to 2,500, we can still sell at the higher valuation. In other words, we would make money in a market downturn. The put option works similar to an insurance policy, and pays off when bad things happen, but does cost a premium to own.

Most of us understand why flood insurance costs more in a flood zone. In the same way, pricing for puts depends on the likelihood of the downside risk coming true. In periods of low market volatility, puts can be a bargain. Using puts to protect around significant event risks while maintaining portfolio exposure to participate in further equity upside could help portfolios. At Russell Investments, we used put options to protect portfolios during the August 2015 sell-off, and again during the Brexit vote in June 2016 to help protect portfolios without trimming our equity exposure to the markets.

Call options and upside risk

Call options work in the opposite way of put options. Call options are contracts that allow the holder the option to buy a security at a specified price within a gated time period. And, because they are buy-oriented, the holder benefits if the price rises. So, instead of having exposure to actual U.S. equities, we can use call options to take advantage of a rise in U.S. equity markets.

Let’s say we bought call options on the S&P at 2,625 and the market rose to 2,700. We could use our options to get paid for the difference—thereby participating in the upside. But, if markets were to drop, our only loss would be the price of the premium for those options, instead of the loss of value to actual equity exposure. As you can see, it’s most advantageous to buy upside through calls when volatility is at multi-year lows.

Right now, our central market-outlook scenario is that U.S. equity markets are unlikely to rise much more, but face a significant risk of downturn. In response, we’ve chosen to reduce our actual exposure to U.S. equities by shorting the market using futures, but buying the upside using call options purchased in early December 2017—to protect against the risk of missing out. As of March 20, 2018, most of our portfolios are approximately 8-15% underweight U.S. equities. In many cases, we are using call options to cover that 8-15%. Our clients get the upside exposure they need, while we aim to drastically reduce the downside risk, for just the price of the options premium. Money well spent, in our opinion.

Because options work, in at least one sense, as insurance against volatility, their premium price is tied to volatility. In simple terms, the greater the volatility, the higher the premium price for options. A small but significant amount of volatility has returned to markets, so options premiums are a bit more expensive than they were in December 2017. So, are they still a wise move? We think so, if volatility stays below average and downside risk is still significant. In any market, but specifically when that combination exists, savvy asset managers will carefully choose the days they purchase options, to try to get the most insurance at the best price. However, we could probably enter a period of heightened volatility as we go deeper into the later part of the cycle in the U.S. If this happens, we would re-evaluate our options exposure to get better risk-adjusted return proposition for our clients.

Necessary capabilities for optionality

An options-inclusive approach isn’t for every asset manager, as we believe success in this space requires two key capabilities:

  1. Robust implementation and trading capabilities. Options trading is a highly specialized skillset. Do it right and it can be a key solution set. But without significant amounts of the right experience—through all market conditions—it’s easy to get it wrong.
  2. Robust risk analytics systems. How will the addition of these instruments impact a portfolio’s total exposures? What’s the right amount of options at any given time? And what is the appropriate amount of overall risk for the investor client? Without integrated and robust risk analysis capabilities, options trading may create unintentional gaps or overweight and actually increase downside risk.

We believe there’s significant value in taking the time to find an asset manager with the right capabilities to bring options into play. Because in today’s market environment, we believe both risks run high: the risk of a market correction and the risk of missing out. Optionality can help.