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Investors often have very polar attitudes toward the market. Conservative investors concerned about deteriorating economic conditions are pushing into bonds while more aggressive and speculative investors are betting that stocks have reached a bottom and are moving back in. More moderate investors are struggling to decide what to do when looking at the two extremes.
There are many ways to blend the two attitudes. You can remain conservative but introduce a little speculation and vice versa.
Imagine that you have a portfolio of $50,000 and you are looking for safety but don’t want to miss out on a market rally should one occur. You could buy bonds with most of that cash balance and blend in some LEAPS calls on the Mini-SPX Index Options (XSP) that will appreciate in value if the market rises while retaining a limited downside.
Assume, for example, that you purchased 2-year investment grade corporate bonds yielding 4% with $47,000 of the cash available. In two years you will have $50,760 for a mild gain just over your original cash balance. The remaining $3,000 could be used to buy LEAPS calls on the XSP with 2 year expirations.
At today’s pricing, that $3,000 will buy two contracts of LEAPS calls. If equities rally, the calls could become very profitable. For example, assume that the market for XSP rallies 50 points over those two years. In that situation, those calls would have profited $3,500 a piece or $7,000 total. The total return on the original $50,000 balance is now 15% or 7.5% per year rather than 4% from bonds alone.
The bond portion of the portfolio protected the original principle. If equities had fallen, the LEAPS would have expired with losses but the original principle would still be intact. This blend of conservative investments and speculative option purchases is a good example of how a risk adverse investor could create some stock market exposure without having to make a decision to invest their entire portfolio in stocks.
In a year that has seen stock market losses wipe out more than 10 years of gains, there is a renewed interest in finding new ways to diversify and spread risk. This example is only one case study of a basic strategic concept. The percentages and balances in this article can be modified and adjusted to account for a higher risk tolerance or a lower one. All any investor needs to execute on ideas like this is an education and a capital balance they want to protect.
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