The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

PORTFOLIO APPLICATIONS OF LISTED OPTIONS

Investors can use the listed options market to address a range of investment problems particularly for active and semi-active managers. We discuss the use of OTC options later. Advantages of listed options relative to OTC options are that they provide accurate and consistent information about pricing and virtually eliminate credit risk. Moreover, because of these characteristics and the standardization of products, listed options often have low transaction costs and moderate to high liquidity. The issue of transaction costs and liquidity can play an important role in the decision to use derivatives as part of the investment process.

Risk Management Strategies

Risk management in the context of equity portfolio management focuses on price risk. Consequently, the strategies discussed here in some way address the risk of a price decline or a loss due to adverse price movement. Options can be used to create asymmetric risk exposures across all or part of the core equity portfolio. This allows the investor to hedge downside risk at a fixed cost with a specific limit to losses should the market turn down. This tactical investment approach can improve risk-adjusted performance versus a benchmark.

The most common strategy for risk management is a protective put buying strategy. This strategy is used by investors who currently hold a long position in the underlying security or investors who desire upside exposure and downside protection. The ...