Options in Portfolio Allocation: A Significant Problem

How do you place a value on options positions within a portfolio? Actually, because of the nature of options it is extremely difficult – if not impossible – to accurately balance an asset allocation target that includes derivatives.   

For example, a portfolio of $1 million specified the following targets:

Large-cap equities: 30%
Mid-cap equities: 10
International equities: 10
Total equities: 50%
Real estate domestic REITs: 20
Real estate directly held: 25
Total real estate: 45%
Derivatives: 5%
Total: 100%

According to this allocation target, the investment manager is allowed to invest $50,000 in derivatives position. But there is a problem. How do you place a value on the derivatives?

For example, what is the value of a synthetic short stock position in which the net between long put and short call is zero? The manager might decide, for example, to open a synthetic short stock position in Verizon VZ. This company closed on May 11, 2012 at $41.16, so opening a synthetic short stock position at a 41 strike could consist of:

• June 41 call 0.84 short
• June 41 put 0.74 long
• Net credit 0.10

Whether this position is opened with one option on either side or with 100, the problem remains. How does this fit with the allocation value of $50,000 (5%) maximum. With only $10 per position (one short call, one long put) there is no effect on the maximum allocation allowance. If you count the potential exercise value, you could create 1,200 short calls and 1,200 long puts. If the 1,200 short calls were all exercised, the portfolio would acquire $49,200 in stock.

However, even if you count the maximum potential exercise as the allocated portion, exercise would add to the equity position, potentially distorting the alpha and beta components of the portfolio and acting contrary to the purpose of tracking risk characteristics

A strategic asset allocation approach may divide a portfolio into the “beta component” in which passive risk-tracking is expected; and the “alpha component,” in which risk-adjusted positions are entered with the intention of adding to profitability. A modern trend in asset allocation is to pair passive index positions with active individual or index positions. It is most likely that derivatives would be classified within the alpha portion of an allocated portfolio, although a beta investment in an index fund including option positions may contradict this assumption.

Asset allocation is aimed at achieving a specific beta for each allocated portion of the portfolio, relative to a benchmark. Returning to the Verizon example, being exercised and required to buy an additional $49,200 of long equities would no doubt throw off the overall beta for the equities portfolio, as well as distorting the equity allocation limits.

So what equities would be appropriate for a derivative section of the allocation? And what positions would be allowed? If the positions create net credits, isn’t the derivative portion unlimited? You need to count some level of “worst case” outcome to limit derivatives activity. For example, AT&T T closed on May 11, 2012 at $33.59. You could create a synthetic long stock position with:

• July 33 call 1.21 long
• July 33 put 0.82 short
• Net debit 0.39

If AT&T remains above the 33 strike, the call (or calls) can be exercised or sold at a profit. If the price falls below the 33 strike, the short puts will be exercised or will need to be closed or rolled to avoid exercise. Here again, depending on how many contracts are opened, the exercised outcome distorts the allocation direction. You could set up 1,500 calls and puts. Exercise of the 1,500 calls would lead to the sale of $49,500 shares. If the short puts were exercised against you, the same result would occur but the price would be above current market value. Both outcomes would distort the allocated equity portion.

Since the purpose of allocation is to diversify the risk and control beta while accomplishing the desired alpha goal, any derivative activity is going to be impossible to value accurately. In the above examples, are the exercise values of the strikes assigned derivative allocation? And if so, what happens upon exercise? Is the beta distorted because the portfolio’s equity portion is taken above limited previously set? They are, of course; so for portfolio managers, defining how derivatives are valued within the allocation field is very troubling.

Even if conservative strategies like covered calls or protective puts represent the limits of allowed hedging activity, the outcomes still affect the overall allocation, notably of equities. In the case of covered calls and protective puts, the equity portion could be taken well below the desired level of allocation, which could have an equally disturbing affect on beta.

Investment managers facing this dilemma may want to limit the types of derivative trades they allow themselves to make. For example, the allocated portion may be specifically limited to long positions in hedge funds or to individual long options for very limited purposes, such as insurance puts to protect paper profits.

However, limitations should also be placed on derivative trades. For example, the specific strategy should be very clearly defined without exception, and no combinations or short positions should be allowed directly. Otherwise, the door is opened to allow investment in much greater levels of risk than intended.

A partial solution is found in the study of volatility, enabling astute investment managers to employ derivatives as risk mitigation short-term strategies rather than as long-term strategic asset allocation components. Anyoption strategies rely on timing, notably for short sides of combinations. Implied volatility rises and falls and you will get maximum premium for the short positions when IV is exceptionally high.

So in addition to identifying risk-management strategies for stock in your portfolio, you also will benefit from tracking IV on the stocks you own, as part of your allocation strategy and beta controls.

A volatility-based strategy can be complex without help, but it can be simple and easy with the right tracking tools. To improve your option trade timing, check the Benzinga service Options & Volatility Edge which is designed to help you improve selection of options as well as timing of your trades