By Derek Moore
Notional value in options and futures can be used to both reduce risk and create risk.
The nuance is understanding which is which. Creating too much leverage can lead to underperformance and worse large losses. Often it seems exceptionally complicated. In experienced hands it can be a powerful tool to shift the risk paradigm.
We utilize notional value to calculate how to participate in market upside while creating floors and buffers.
Want to once and for all understand it?
Examples of Options Notional Value
Options can be used to control but not own and underlying asset. Standard option contracts represent 100 shares of the underlying symbol, so the notionally control an option represents is simply 100 times the price of the underlying. For example...
- 1 Call Option on the SPY at 450 represents $45,000 notional (100 x 450)
- 1 Call Option on the SPX at 4500 represents $450,000 notional (100 x 4500)
Benefits of Notional Value We Implement in Buy and Hedge Retirement
- With a $450,000 portfolio we can use 1 SPX or 10 SPY to control but not own shares in the S&P 500 Index
- With ≈ 9% of the total assets we can pay the premium to purchase the calls and have the same notional exposure as if we bought the shares.
- The cost of the calls also represents the max loss of the position because you cannot lose more than what you paid for the long calls.
- With the remaining amount we can use some yield bearing positions like hedged high yield bonds to help pay for our cost of the notional control of the S&P 500
Mistakes Investors Can Make Using Notional Exposure
- Using too many contracts that would up the leverage and increase risk of losses
- Controlling way more of the underlying asset than the account size
- For example, in a $450,000 account using 10 SPX 4500 Calls would control $4.5millon of notional exposure.
Now you know how we use notional exposure to create downside floors in portfolios.
We use a little amount of the portfolio to control but no own the S&P 500 Index. Either through the SPY ETF shares or the SPX Index itself.
With most of the account, we invest those funds into short duration high yield bonds via ETFs while also hedging a good portion of that piece.
The result is we get to participate in a portion of the upside of the market while limiting the equity downside to 8% – 10% down.
Let us know if you want more information on who we reduce risk for. Chances are it’s the very groups of clients who need it most.