Trading a Combination of Index Options and Bonds

09/25/2009 12:01 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Traders often have very polar attitudes towards the market. Conservative traders concerned about deteriorating economic conditions are pushing into bonds, while more aggressive and speculative traders 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. The video accompanying this article will walk through one way that this blending concept can be applied with a portfolio comprised of bonds and options.

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 LEAP calls on the S&P 500 mini-index options (XSP) that will appreciate in value if the market rises while retaining a limited downside.

Assume for example that you purchased two-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 LEAP calls on the XSP with two-year expirations.

At today's pricing, that $3,000 will buy two contracts of LEAP 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-averse 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 ten 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.

Watch the video:

By John Jagerson of LearningMarkets.com.

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