By Atul Parakh
Strategic Portfolio Allocation is an investment strategy that aims to decrease risk by investing in different asset classes, such as equity, commodities, real estate, and bonds. The theory of strategic portfolio allocation helps investors lessen market risk through diversification.
Imagine a scenario where you hold shares of XYZ companies, but that particular sector is showing signs of correction. The value of your shares is declining but without selling the shares, you are finding ways to make a few bucks. Is it possible?
Yes, it’s possible to make money in a declining market phase. The instruments used to tackle these scenarios are known as derivatives. These financial instruments give investors the flexibility to hold their investments while trading in the direction of the trend.
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Equity derivatives can be divided into two segments: futures and Options. Derivatives allow investors or traders to build larger positions by investing a small portion of money in futures and options.
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Derivatives are leveraged financial instruments which can be used for strategic portfolio allocation. Before diving into details, let’s get a basic understanding of Futures and options.
What are Futures Contracts?
Futures are financial contracts obligating buyers to purchase or sellers to sell assets. It is possible in equity, commodities, and currencies at a predetermined future date and price.
Acting as a risk management tool, futures allow investors to hedge against price fluctuations. Traders speculate on the future value of commodities, currencies, or financial instruments, facilitating price discovery and market liquidity.
These standardised agreements are traded on organized exchanges, providing a transparent platform for participants in the global financial markets.
What are Options Contracts?
Options are financial instruments granting the buyer the right, but not the obligation, to buy, Call (CE), or sell Put (PE) an underlying asset at a predetermined price within a specified timeframe.
This flexibility provides investors strategic leverage in managing risk or capitalizing on market movements.
Options trading involves predicting price fluctuations and offers a versatile approach for hedging, speculation, or income generation. It’s a nuanced tool that empowers traders with diverse strategies for navigating financial markets.
How Derivatives Can Help in Strategic Portfolio Allocation?
Derivatives can be beneficial for strategic portfolio allocation. It can be used in risk management through hedging, diversification, and income generation. Here are two famous option strategies which can help in strategic portfolio allocation.
Covered Call Trading Strategy
This is an options trading strategy used by many long-term investors to generate income. In a covered call, investors sell a Call option (CE) of an under-asset and receive a premium amount. If the underlying asset price stays below the strike sold till the expiry, then the option premium will decay, and investors get the benefit.
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This strategy is deployed by investors when they believe that underlying stock may witness minor fluctuation, but prices of underlying may not rise much.
However, if the investors believe that the underlying price may show a substantial rise, then a covered call strategy must be avoided.
Strangle Option Strategy
This strategy is very famous among traders and investors. We often see a stock in our portfolio consolidating in a wide range for quite a long time. In the consolidation phase, investors may fail to generate returns. To tackle this type of sc
In Strangle, investors sell an out-the-money (OTM) call option and a money (OTM) put option to receive a premium. Till the underlying stays in a range, the option premium will slowly decay and generate income.
This strategy is suitable for a low-volatility market. However, if the underlying stock displays a sharp rise or fall, strangle may not work as expected.
Conclusion
Strategic Portfolio Allocation refers to an investment strategy used by long term investors to rebalance the portfolio. To generate better returns, investors need to diversify their portfolios by allocating the money to different classes of assets.
However, in the above article, equity derivatives option strategies are used to manage the risk and rebalance the portfolio in the same asset class. Consulting with a financial advisor is recommended before incorporating derivatives into a portfolio.
(Atul Parakh is CEO at Bigul, the digital arm of brokerage Bonanza Portfolio . Views expressed are the author’s own. Please consult your financial advisor before investing.)
