Altering Your Portfolio With Options

Posted By: Advisor Analyzer Team

 

When it comes to food, people have differing tastes. Some prefer salads with olives, while others choose to deftly eat around them. Although dissimilar in the edible sense, your investment portfolio is not unlike that tossed bowl of romaine lettuce and fresh green peppers served at your favorite Friday night restaurant. Both are a mixture of individual components each with a distinct taste, which combined create a unique new outcome.

 

However, while enjoying an olive free salad requires little more than the adroit use of one’s fork, fine tuning an investment portfolio to one’s specific taste may require a tad more ingenuity. Fortunately, by using options, configuring a portfolio to one’s preferences has never been easier.

 

To demonstrate, let’s examine the Dow Jones Industrial Average (DJIA) for August 27, 2008. The Dow closed at 11,502.51 up 89.64 for the day. Since the Diamonds Trust Series 1 (DIA) is the Exchange Traded Fund (ETF) tracking the Dow, we’ll also view DIA which closed at 115.00.

 

8/27/08	Day's Close	Day's Move	Open	Daily High	Daily Low
Diamonds (DIA)	115.00	(-.93)	114.24	115.59	113.84

 

The Dow is a price weighted index of 30 NYSE and NASDAQ stocks including Microsoft (MSFT), Johnson and Johnson (JNJ), Exxon Mobil (XOM) to name a few. Each stock’s price change proportionately affects the Dow’s movement by their concurrent weights. Below are the companies included in the Dow Jones Index.

 

Company	Price	Company	Price	Company	Price
3M	70.72	Chevron	86.62	Alcoa	32.08
Citigroup	18.12	AIG	20.00	Coca-Cola	53.79
American Express	38.82	Dupont	44.34	BAC	29.65
Boeing	64.52	GM	10.20	Caterpillar	69.56
Home Depot	27.17	Microsoft	27.56	IBM	123.38
Pfizer	19.08	Intel	23.41	P & G	70.06
Johnson & Johnson	71.21	United Tech	65.05	JPM Chase	37.14
Verizon	34.71	McDonalds	62.08	Wal-Mart	59.29
Merck and Co.	35.73	Disney	31.76

 

Suppose you would like your portfolio to mirror the Dow for the coming month.  There are several ways this can be achieved, the easiest being proportionately purchase the 30 stocks that comprise the Dow.  However, buying and consequently selling 30 stocks for a month’s market exposure may be least efficient once transaction costs are considered.  Say the Dow remains flat that month; the cost to buy and sell 30 stocks would most likely leave you in the red (since you pay for 30 X 2 = 60 transactions). 

 

Assuming ETF’s are without tracking error, the Diamonds fund (DIA), provides the desired market exposure but more efficiently.  Here, 60 transactions are whittled to two: the purchase of DIA, and the subsequent sale in a month’s time.  Assuming only cash positions, the cost to purchase 100 shares of Diamonds is $11,500.00 before commissions.  While more cost effective than the outright purchase and sale of 30 stocks, some may find $11,500 to be less affordable if it’s a substantial portion of one’s portfolio.

 

But what options are available aside from the above mentioned?  The answer is (quite deliberately) embedded in the question.  Suppose an individual would like to purchase 100 DIA shares, but faces a capital shortage in their portfolio.  Through options transactions (or just derivatives as a whole), one can synthetically obtain identical market exposure for a fraction of the required capital.  Before making that call to the Securities Exchange Commission, allow me to elaborate.

 

Call	Price	Move	Open Int	Strike
UTXIM.X	1.65	56	3082	65.00

 

Put	Price	Volume	Open Int	Strike
UTXUM.X	1.60	583	1205	115.00

 

Also, this article is designed to address the conceptual mechanics behind altering portfolio exposures via options. The number of contracts needed to accurately alter position exposures depends not only on the weight of each position, but the correlations shared with the other companies as well.  For example, a change in Exxon Mobil Corp. (XOM), would not only impact the Dow; it may affect Chevron Corp (CVX) prices, which also affects the Dow.  For ease of calculation we assume correlations to be zero (e.g. no stock is affected by the movements of another).

Suppose a former United Technologies (UTX) engineer would like Dow exposure for the month, but objects any UTX exposure. Short of individually purchasing the remaining 29 companies, the engineer could simply purchase DIA. However, doing so indirectly creates UTX exposure, placing his wallet and beliefs at odds.  UTX reflects 4.60% of the Dow; therefore, ceteris paribus, a 10.00% UTX gain consequently increases the Dow .46% (=4.60% X 10.00%). Since the optimal portfolio must negate any effects of UTX, a method must be determined to omit the resulting .46% gain from the DIA position.

 

To achieve this, a transaction eliminating any UTX effects from our portfolio is needed. Ideally, a UTX free portfolio should effectively offset a 1% UTX gain with equivalent loss. While simply shorting UTX seems most intuitive, there are interest free options available that yield similar results.   A frugal alternative entails the employment of options. Buying the UTX 65 puts, while simultaneously shorting the UTX 65 calls synthetically creates a short UTX position. Conversely, purchasing the 20.00 calls for American International Group (AIG) and selling the 20.00 puts creates a synthetic long AIG position. Doing so increases the overall portfolio exposure to AIG, without actually purchasing the underlying.

 

Conceptually a fairly straight forward strategy however, determining the correct number of contracts that eliminates unwanted exposure proves more challenging. First, the impact of a 1% UTX move on DIA must be assessed. Assuming UTX shares zero correlation, the answer would be .046% (=4.60% X 1%).

 

Suppose we purchased 6,505 shares of DIA, for a total cost of $748,075.  UTX reflects 4.60% or $34,411.50 (=$748,075 X 4.60%) in dollar terms. Given the $65.05 closing price, this equivalent to 529 (=$34,411.50 ÷ $65.05) UTX shares. Since option contracts represent 100 shares, 5.29 (or roughly ~5) UTX contracts are needed.

 

UTX 65 puts are $1.60, making the total purchase price $800 (= 1.60 X 5 X 100).  UTX 65 calls are $1.65 each, and funds received from the short sale is $825 (= 1.65 X 5 X 100). Therefore, the net cost in removing substantial UTX exposure from our $748,075 portfolio is a credit of $25 (=$825 – $800). Although an increase in UTX creates a proportionate DIA gain, the loss from our short call position offsets a majority of this move. Likewise, a drop in UTX prices depreciates our DIA position, but the long put position largely compensate for losses caused by UTX.

Conclusion:

By utilizing combinations of various options, we can synthetically create a portfolio optimally tailored to our unique tastes. Options are a practical alternative to individual stocks and more cost effectively support portfolio alterations. Returning to our salad analogy, using options is similar to having an olive loving wife picking all the olives from your salad bowl: although there, you’re protected from experiencing the effects.