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There’s still plenty of downside in this market, but options can protect clients.

So say Hans Albrecht and Nicolas Piquard, options strategists and VPs at Horizons ETFs.

“We saw some panic last week that we haven’t seen since 2009,” says Albrecht. “Volumes on vol products were breaking records.”

And while things are calmer this week, says Piquard, “Small caps are still down on the year, and they were leaders at the beginning of the year. Market gains are being driven by fewer stocks. PE levels remain elevated. Profit margins are at record highs, and those tend to mean revert.”

Read: Panicked clients? Here’s help

The pair oversees the firm’s Black Swan ETF, which seeks to protect invested capital if the market drops more than 10%. To do so, they use put options for capital protection, which gives clients an alternative to bailing into cash.

They’re currently targeting a 10% to 15% out-of-the-money level. “We consider 5% to 8% pullbacks normal, even in a healthy market,” says Albrecht. “We’re more concerned about the severe sell-offs. That’s when you want a capital preservation strategy to kick in.” He adds a 10% to 15% target works because at that point, the options’ carrying costs don’t unduly reduce performance.

Piquard varies put purchases based on volatility levels. When vol’s low, “we like to buy longer-dated put options because the premium is relatively inexpensive. When volatility’s higher and that protection becomes more expensive, we look at buying shorter-term options,” which become cheaper.

Read: Learn to love volatility: Taleb

The team also sells calls “to generate money to buy put protection. In a high-volatility environment, calls are going to get us a lot of money.”

This strategy typically results in positive returns when the market is down at least 10%, and 75% to 80% participation in an up market.

“We’ve seen advisors replace 25% of equity exposure with a Black Swan allocation,” says Albrecht. “That way, if there’s a crash, they’re only going to be down on 75% of their equity exposure, and they’re going to up on that other 25%. Meanwhile, on the upside, they’re still mostly participating in the equity markets.”

Read: How to battle market fatigue

Originally published on Advisor.ca

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