Implementing portfolio protection via the use of options can prevent investors from experiencing significant losses caused by periods of extreme market volatility, according to an executive specialising in derivatives.
“During the global financial crisis (GFC), most of us did nothing, sat on our stocks and hoped that the market would perform better,” Australian Securities Exchange (ASX) manager of equity derivatives Graham O’Brien told the recent ASX Investor Day in Sydney.
“The best thing we should’ve done was to sell our stocks pre-GFC, put the money in the bank, and then bought back into the market when it performed [again]. That’s great with hindsight but not many of us can pick leading into it.
“So how can we go about protecting ourselves no matter how far the market might fall? We might be able to build in some protection into our portfolios.”
O’Brien pointed out SMSF investors could reduce share market risk without selling their shares by purchasing portfolio protection from the options market.
“It will only be used if the market falls significantly on us,” he explained.
“We look to implement a strategy that will return us cash to offset the losses that we make on our portfolio and, importantly, we don’t want to sell our shares and trigger capital gains tax.
“The SMSF will continue to receive dividends and franking credits.
“And we don’t implement that protection if the market was to rally; we only use it if the market falls in value.”
Highlighting some of the risks of using options, O’Brien said it will only work on a diversified share portfolio.
“And while it protects us from falls in the market, it is costly,” he warned.
“Unfortunately when markets rally, we are going to underperform so it does act like an insurance policy and it does also expire, so you need to be mindful of how long you’re nervous for.”